[Federal Register Volume 63, Number 58 (Thursday, March 26, 1998)]
[Rules and Regulations]
[Pages 14613-14620]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-7891]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 301
[TD 8767]
RIN 1545-AWO7
Guidance Under Subpart F Relating to Partnerships and Branches
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Temporary and final regulations.
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SUMMARY: This document contains regulations relating to the treatment
under subpart F of certain payments involving branches of a controlled
foreign corporation (CFC) that are treated as separate entities for
foreign tax purposes or partnerships in which CFCs are partners. These
regulations are necessary to provide guidance on transactions relating
to such entities. These regulations will affect United States
shareholders of controlled foreign corporations. The text of these
temporary regulations also serves as the text of the proposed
regulations published elsewhere in this issue of the Federal Register.
DATES: Effective date: These regulations are effective March 23, 1998.
Applicability date: For dates of applicability see Secs. 1.904-
5T(o), 1.954-1T(c)(1)(i)(E), 1.954-2T(a)(5)(iii) and (a)(6)(ii), 1.954-
9T(d) and 301.7701-3T(f) of these regulations.
FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background
I. In General
In these temporary regulations and in proposed regulations
published elsewhere in this issue of the Federal Register, the Treasury
and IRS set forth a framework for dealing with issues posed by the use
of certain entities that are regarded as fiscally transparent for
purposes of U.S. tax law, with regard to the application of subpart F
of the Internal Revenue Code.
Subpart F was enacted by Congress to limit the deferral of U.S.
taxation of certain income earned outside the United States by foreign
corporations controlled by U.S. persons. Limited deferral was retained
after the enactment of subpart F to protect the competitiveness of
controlled foreign corporations (CFCs) doing business overseas. See S.
Rep. No. 1881, 87th Cong., 2d Sess. 78-80 (1962). This limited deferral
furthers the objective of allowing a CFC engaged in an active business,
and located in a foreign country for appropriate economic reasons, to
compete in a similar tax environment with non-U.S.-owned corporations
located in the same country.
Conversely, one of the purposes of subpart F is to prevent CFCs
from converting active income that is not easily moveable and is earned
in a jurisdiction in which a business is located for non-tax reasons,
into passive, easily moveable income that is shifted to a lower tax
jurisdiction primarily for tax avoidance. Moreover, when subpart F was
first enacted it was realized that related person transactions can be
easily manipulated to reduce both United States and foreign taxes.
Consequently, in enacting subpart F, Congress provided that
transactions of CFCs that involve related persons generally give rise
to subpart F income with certain enumerated exceptions.
Hybrid branches, which, by definition, are not regarded as fiscally
transparent under foreign law, are particularly well suited to the type
of tax avoidance described above. In light of the recent proliferation
of hybrid branches, Treasury and the IRS believe that it is appropriate
to consider the issues related to transactions involving hybrid
branches, or other hybrid entities, under subpart F.
The use of partnerships that are fiscally transparent for U.S. tax
purposes raises additional issues in the context of subpart F that are
similar to those raised in connection with hybrid branches. Such
partnerships may or may not be fiscally transparent under foreign law.
(Other fiscally-transparent entities, such as grantor trusts, will be
the subject of guidance issued in conjunction with the finalization of
regulations under section 672(f).)
The entity classification regulations of Secs. 301.7701-1 through
301.7701-3 (the check-the-box regulations) make entity classification
generally elective, in part so that taxpayers can choose a tax status
that is consistent with their business objectives. This administrative
provision was not intended to change substantive law. Particularly in
the international area, the ability to more easily achieve fiscal
transparency can lead to inappropriate results under certain
substantive international provisions of the Code. Thus, the Treasury
and the IRS believe that it is necessary to provide additional guidance
regarding the use of hybrid entities in the international context. See
[[Page 14614]]
preamble to TD 8697, 61 FR 66585 (December 18, 1996).
II. Hybrid Branches
As announced in Notice 98-11 (1998-6 I.R.B. 13), the Treasury and
the IRS understand that certain taxpayers are using arrangements
involving hybrid branches to circumvent the purposes of subpart F
(sections 951 through 964 of the Code). These arrangements generally
involve the use of deductible payments to reduce the taxable income of
a CFC under foreign law, thereby reducing that CFC's foreign tax and,
also under foreign law, the corresponding creation in another entity of
low-taxed, passive income of the type to which subpart F was intended
to apply. Because of the structure of these arrangements, however,
taxpayers take the position that this income is not taxed under subpart
F. Treasury and the IRS have concluded that use of these hybrid branch
arrangements is contrary to the policies and rules of subpart F.
U.S. international tax policy seeks to balance the objective of
neutrality of taxation between domestic and foreign business
enterprises (seeking neither to encourage nor to discourage one over
the other), while keeping U.S. business competitive. Subpart F strongly
reflects and enforces that balance, while the arrangements described
above involving hybrid branches upset that balance.
Explanation of Provisions
Under these temporary regulations, hybrid branch payments, as
defined in the regulations, between a CFC and its hybrid branch, or
between hybrid branches of the CFC may give rise to subpart F income.
When certain conditions are present, the non-subpart F income of the
CFC, in the amount of the hybrid branch payment, is recharacterized as
subpart F income of the CFC. Those conditions include that: the hybrid
branch payment reduces the foreign tax of the payor; the hybrid branch
payment would have been foreign personal holding company income if made
between separate CFCs; and there is a disparity between the effective
rate of tax on the payment in the hands of the payee and the
hypothetical rate of tax that would have applied if the income had been
taxed in the hands of the payor. Treasury and the IRS are considering
applying similar principles with respect to the foreign base company
services income rules of section 954(e). Comments are requested on this
issue. Any regulations promulgated on this issue will be prospective.
Policies underlying subpart F would also be avoided in certain non-
hybrid branch transactions that do not reduce the tax of the payor.
Treasury and the IRS invite comments on the extent to which rules
should be provided to address such transactions. Any regulations
promulgated on this issue will be prospective. Comments are also
requested regarding the application of these rules to dividend and
other equity distributions.
The temporary regulations make clear that the CFC and the hybrid
branch, or the hybrid branches, are treated as separate corporations
only to recharacterize non-subpart F income as subpart F income in the
amount of the hybrid branch payment, and to apply the tax disparity
rule of Sec. 1.954-9T(a)(5)(iv). For all other purposes (e.g., for
purposes of the earnings and profits limitation of section 952), a CFC
and its hybrid branch, or hybrid branches, are not treated as separate
corporations.
The temporary regulations provide that the amount recharacterized
as subpart F income is the gross amount of the hybrid branch payment
limited by the amount of the CFC's earnings and profits attributable to
non-subpart F income. This amount is the excess of current earnings and
profits over subpart F income, determined after the application of the
rules of sections 954(b) and 952(c) and before the application of these
temporary regulations. To the extent that the full amount required to
be recharacterized under this provision cannot be recharacterized
because it exceeds earnings and profits attributable to non-subpart F
income, there is no requirement to carry such amounts back or forward
to another year.
For purposes of determining the amount of taxes deemed paid under
section 960, the amount of non-subpart F income recharacterized as
subpart F income is treated as attributable to income in separate
foreign tax credit baskets in proportion to the ratio of non-subpart F
income in each basket to the total amount of non-subpart F income of
the CFC for the taxable year.
The temporary regulations provide that, under certain
circumstances, the recharacterization rules will also apply to a CFC s
proportionate share of any hybrid branch payment made between a
partnership in which the CFC is a partner and a hybrid branch of the
partnership, or between hybrid branches of such a partnership. When the
partnership is treated as fiscally transparent by the CFC's taxing
jurisdiction, the recharacterization rules are applied by treating the
hybrid branch payment as if it had been made directly between the CFC
and the hybrid branch, or as though the hybrid branches of the
partnership had been hybrid branches of the CFC, as applicable. If the
partnership is treated as a separate entity by the CFC's taxing
jurisdiction, the recharacterization rules are applied to the
partnership as if it were a CFC. Comments are requested on whether the
rule for such non-fiscally transparent partnerships should be relaxed
in the case of small ownership interests.
The temporary regulations provide that income will not be
recharacterized unless there is a disparity between the effective rate
at which the hybrid branch payment is taxed to the payee and a
hypothetical tax rate that measures the tax savings to the payor from
the deductible payment. This provision is similar to the rule in
Sec. 1.954-3(b), and adopts the same percentage tests as contained in
that provision. The regulations also provide a special high tax
exception applicable to the hybrid branch payment that is similar to
the one contained in section 954(b)(4). Comments are invited on whether
the rules of Sec. 1.954-9T could cause inappropriate multiple
recharacterizations where the hybrid branch payments are made through a
series of related hybrid entities.
The temporary regulations provide that if these provisions affect
an entity that has elected under Sec. 301.7701-3(c) to be treated as an
entity disregarded as separate from its owner, such an entity may elect
to be classified as a corporation, provided it fulfills certain
requirements, notwithstanding the sixty-month limitation in that
section.
III. Related Provisions
These temporary regulations provide rules, contained in Sec. 1.954-
1T(c)(1)(i)(B), to prevent expenses, including related person interest
expense which would normally be allocable under section 954(b)(5) to
subpart F income of a CFC, from being allocated to a payment from which
the expense arises. The allocation limit applies: (i) to the extent
such payment is included in the subpart F income of the CFC; (ii) if
the expense arises from any payment by the CFC to a hybrid partnership
in which the CFC is a partner; and (iii) if the payment reduces foreign
tax and there is a significant disparity in tax rates between the payor
and payee jurisdictions.
These temporary regulations also address the application of the
related person exceptions to the foreign personal holding company
income rules in the context of partnership distributive shares and
transactions involving hybrid branches. Under section 954(c)(3),
foreign personal
[[Page 14615]]
holding company income does not include certain interest, dividends,
rents and royalties received from related corporations. These
exceptions apply, in the case of interest and dividends, when the
related corporate payor is organized in the country in which the CFC is
organized and uses a substantial part of its assets in a trade or
business in that country and, in the case of rents and royalties, when
the rent or royalty payment is made for the use or privilege of using
property within the CFC's country of incorporation.
The rules regarding the application of the related person
exceptions with respect to a CFC partner's distributive share of
partnership income are part of the broader set of rules addressing
distributive share issues in the context of subpart F contained in the
proposed regulations published elsewhere in this issue of the Federal
Register. Certain rules relating to the related person exception with
respect to a CFC partner's distributive share of partnership income,
and certain rules relating to the related person exception with respect
to hybrid branches, however, are included in these temporary
regulations because they address a fact pattern similar to the one to
which the hybrid branch payment rules apply. No inference is intended
as to the treatment under existing law of such arrangements in relation
to the related party exceptions.
Under these rules, if the partnership receives an item of income
that reduces the income tax of the payor, the related person exceptions
of section 954(c)(3) apply to exclude the income from the foreign
personal holding company income of the CFC partner only where: the
exception would have applied if the CFC earned the income directly
(testing relatedness and country of incorporation at the CFC partner
level); and either the partnership is organized and operates in the
CFC's country of incorporation, the partnership is treated as fiscally
transparent in the CFC's countries of incorporation and operation, or
there is no significant disparity between the effective rate of tax
imposed on the income and the rate of tax that would be imposed on the
income if earned directly by the CFC partner.
The rules applying the related person exceptions with respect to
hybrid branches address transactions illustrated in the first example
of Notice 98-11 (1998-6 I.R.B. 13). These rules apply to payments by a
CFC to a hybrid branch of a related CFC. Under these rules, the related
person exceptions will apply to exclude the payments from the foreign
personal holding company income of the recipient CFC only if the
payment would have qualified for the exception if the hybrid branch had
been a separate CFC incorporated in the jurisdiction in which the
payment is subject to tax (other than a withholding tax).
IV. Effective Date.
These regulations are effective March 23, 1998. For dates of
applicability see Secs. 1.904-5T(o), 1.954-1T(c)(1)(i)(E), 1.954-
2T(a)(5)(iii) and (6)(iii), 1.954-9T(d) and 301.7701-3T(f) of these
regulations.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedures Act (5
U.S.C. chapter 5) does not apply to these regulations and, because the
regulation does not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these
temporary regulations will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on their
impact on small business.
Drafting Information
The principal author of these regulations is Valerie Mark, of the
Office of the Associate Chief Counsel (International). Other personnel
from the IRS and Treasury Department also participated in the
development of these regulations.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income
taxes, Penalties, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 301 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for 26 CFR part 1 continues to
read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In Sec. 1.904-5, paragraph (o) is amended by adding a
sentence at the end to read as follows:
Sec. 1.904-5 Look-through rules as applied to controlled foreign
corporations and other entities.
* * * * *
(o) * * * Paragraph (k)(1) of this section does not apply on or
after March 23, 1998. For rules applicable on or after March 23, 1998,
see Sec. 1.904-5T(k)(1).
Par. 3. Sec. 1.904-5T is added to read as follows:
Sec. 1.904-5T Look-through rules as applied to controlled foreign
corporations and other entities (temporary).
(a) through (j) [Reserved]. For further guidance, see Sec. 1.904-
5(a) through (j).
(k) Ordering rules--(1) In general. Income received or accrued by a
related person to which the look-through rules apply is characterized
before amounts included from, or paid or distributed by, that person
and received or accrued by a related person. For purposes of
determining the character of income received or accrued by a person
from a related person if the payor or another related person also
receives or accrues income from the recipient and the look-through
rules apply to the income in all cases, the rules of paragraph (k)(2)
of this section apply. Notwithstanding any other provision of this
section, the principles of Sec. 1.954-1T(c)(1)(i) will apply to any
expense subject to that subparagraph.
(k)(2) through (n) [Reserved]. For further guidance, see
Sec. 1.904-5(k)(2) through (n).
(o) Effective date. Section 1.904-5T(k)(1) applies on or after
March 23, 1998. For rules prior to March 23, 1998, see Sec. 1.904-
5(k)(1).
Par. 4. Section 1.954-0(b) is amended by revising the paragraph
heading and the entry for Sec. 1.954-0(b) in the list to read as
follows:
Sec. 1.954-0 Introduction.
* * * * *
(b) Outline of Secs. 1.954-0, 1.954-1 and 1.954-2.
Sec. 1.954-0 Introduction.
* * * * *
(b) Outline of Secs. 1.954-0, 1.954-1, and 1.954-2.
* * * * *
Par. 5. Section 1.954-1 is amended by adding a new paragraph
(c)(1)(iv) to read as follows:
Sec. 1.954-1 Foreign base company income.
* * * * *
(c) * * *
(1) * * *
(iv) Effective date. Paragraph (c)(1)(i) of this section does not
apply to all
[[Page 14616]]
amounts paid or accrued on or after March 23, 1998 except for amounts
paid or accrued pursuant to arrangements entered into before March 23,
1998 and not substantially modified (including, for example, by
expansion of the arrangement (whether by exercise of an option or
otherwise) such as by an increase in the amount of or term of any
borrowing, leasing or licensing constituting the arrangement, changes
in direct or indirect control of any entity that is a party to the
arrangement, or any similar measure which materially increases the tax
benefit of the arrangement) on or after March 23, 1998. For rules
applicable on or after March 23, 1998, see Sec. 1.954-1T(c)(1)(i).
Par. 6. Section 1.954-1T is added to read as follows:
Sec. 1.954-1T Foreign base company income (temporary).
(a) through (c)(1)(i) [Reserved]. For further guidance, see
Sec. 1.954-1(a) through (c)(1).
(c)(1)(i) Deductions against gross foreign base company income--(A)
In general. [Reserved]. For further guidance, see Sec. 1.954-
1(c)(1)(i).
(B) Special rule for deductible payments to certain non-fiscally
transparent entities. Notwithstanding any other provision of this
section, except as provided in paragraph (c)(1)(i)(C) of this section,
an expense (including a distributive share of any expense) that would
otherwise be allocable under section 954(b)(5) against the subpart F
income of a controlled foreign corporation shall not be allocated
against subpart F income of the controlled foreign corporation
resulting from the payment giving rise to the expense if--
(1) Such expense arises from a payment between the controlled
foreign corporation and a partnership in which the controlled foreign
corporation is a partner and the partnership is not regarded as
fiscally transparent, as defined in Sec. 1.954-9T(a)(7), by any country
in which the controlled foreign corporation does business or has
substantial assets; and
(2) The payment from which the expense arises would have met the
foreign tax reduction test of Sec. 1.954-9T(a)(3) and the tax disparity
test of Sec. 1.954-9T(a)(5)(iv) if those provisions had been applicable
to the payment.
(C) Limitations. Paragraph (c)(1)(i)(B) shall not apply to the
extent that the controlled foreign corporation partner has no income
against which to allocate the expense, other than its distributive
share of a payment described in paragraph (c)(1)(i)(B) of this section.
Similarly, to the extent an expense described in paragraph (c)(1)(i)(B)
of this section exceeds the controlled foreign corporation partner's
distributive share of the payment from which the expense arises, such
excess amount of the expense may reduce subpart F income (other than
such payment) to which it is properly allocable or apportionable under
section 954(b)(5).
(D) Example. The following example illustrates the application of
paragraph (c)(1)(i)(B) and (C) of this section:
Example. CFC, a controlled foreign corporation in Country A, is
a 70 percent partner in partnership P, located in Country B. Country
A's tax laws do not classify P as a fiscally transparent entity. The
rate of tax in country B is 15 percent of the tax rate in country A.
P loans $100 to CFC at a market rate of interest. In year 1, CFC
pays P $10 of interest on the loan. The interest payment would have
caused the recharacterization rules of Sec. 1.954-9T to apply if the
payment were made between the entities described in Sec. 1.954-
9T(a)(2). CFC's distributive share of P's interest income is $7,
which is foreign personal holding company income to CFC under
section 954(c). Under paragraph (c)(1)(i)(B) of this section, $7 of
the $10 interest expense may not be allocated against any of CFC's
subpart F income. However, to the extent the remaining $3 of
interest expense is properly allocable to subpart F income of CFC
other than its distributive share of P's interest income, this
expense may offset such other subpart F income.
(E) Effective date. Paragraph (c)(1)(i)(B), (C) and (D) of this
section shall apply to all amounts paid or accrued on or after March
23, 1998, except for amounts paid or accrued pursuant to arrangements
entered into before March 23, 1998 and not substantially modified
(including, for example, by expansion of the arrangement (whether by
exercise of an option or otherwise) such as by an increase in the
amount of or term of any borrowing, leasing or licensing constituting
the arrangement, changes in direct or indirect control of any entity
that is a party to the arrangement, or any similar measure which
materially increases the tax benefit of the arrangement) on or after
March 23, 1998. For rules applicable to amounts paid or accrued
pursuant to arrangements entered into before March 23, 1998, see
Sec. 1.954-1.
(c)(1)(ii) through (f) [Reserved]. For further guidance, see
Sec. 1.954-1(c)(1)(ii) through (f).
Par. 7. Section 1.954-2T is added to read as follows:
Sec. 1.954-2T Foreign personal holding company income (temporary).
(a)(1) through (4) [Reserved]. For further guidance, see
Sec. 1.954-2(a) through (4).
(5) Special rules applicable to distributive share of partnership
income--(i) Application of related person exceptions where payment
reduces foreign tax of payor. If a partnership receives an item of
income that reduced the foreign income tax of the payor (determined
under the principles of Sec. 1.954-9T(a)(3)), to determine the extent
to which a controlled foreign corporation's distributive share of such
item of income is foreign personal holding company income, the
exceptions contained in section 954(c)(3) shall apply only if--
(A)(1) Any such exception would have applied to exclude the income
from foreign personal holding company income if the controlled foreign
corporation had earned the income directly (determined by testing, with
reference to such controlled foreign corporation, whether an entity is
a related person, within the meaning of section 954(d)(3), or is
organized under the laws of, or uses property in, the foreign country
in which the controlled foreign corporation is created or organized);
and
(2) The distributive share of such income is not in respect of a
payment made by the controlled foreign corporation to the partnership;
and
(B)(1) The partnership is created or organized, and uses a
substantial part of its assets in a trade or business in the country
under the laws of which the controlled foreign corporation is created
or organized (determined under the principles of Sec. 1.954-2(b)(4));
(2) The partnership is regarded as fiscally transparent, as defined
in Sec. 1.954-9T(a)(7), by all countries under the laws of which the
controlled foreign corporation is created or organized or has
substantial assets; or
(3) The income is taxed in the year when earned at an effective
rate of tax (determined under the principles of Sec. 1.954-1(d)(2))
that is not less than 90 percent of, and not more than five percentage
points less than, the effective rate of tax that would have applied to
such income under the laws of the country in which the controlled
foreign corporation is created or organized if such income were earned
directly by the controlled foreign corporation partner from local
sources.
(ii) Certain other exceptions applicable to foreign personal
holding company income. [Reserved].
(iii) Effective date. Paragraph (a)(5)(i) of this section shall
apply to all amounts paid or accrued on or after March 23, 1998, except
for amounts paid or accrued pursuant to arrangements entered into
before March 23, 1998 and
[[Page 14617]]
not substantially modified (including, for example, by expansion of the
arrangement (whether by exercise of an option or otherwise) such as by
an increase in the amount of or term of any borrowing, leasing or
licensing constituting the arrangement, changes in direct or indirect
control of any entity that is a party to the arrangement, or any
similar measure which materially increases the tax benefit of the
arrangement) on or after March 23, 1998.
(6) Special rules applicable to exceptions from foreign personal
holding company income treatment in circumstances involving hybrid
branches--(i) In general. In the case of a payment between a controlled
foreign corporation (or its hybrid branch, as defined in Sec. 1.954-
9T(a)(6)) and the hybrid branch of a related controlled foreign
corporation, the exceptions contained in section 954(c)(3) shall apply
only if the payment would have qualified for the exception if the payor
were a separate controlled foreign corporation created or organized in
the jurisdiction where foreign tax is reduced and the payee were a
separate controlled foreign corporation created or organized under the
laws of the jurisdiction in which the payment is subject to tax (other
than a withholding tax).
(ii) Exception where no tax reduction or tax disparity. Paragraph
(a)(6)(i) of this section shall not apply unless the payment would have
met the foreign tax reduction test of Sec. 1.954-9T(a)(3) and the tax
disparity test of Sec. 1.954-9T(a)(5)(iv) if those provisions had been
applicable to the payment.
(iii) Effective date. The rules of this section shall apply to all
amounts paid or accrued on or after January 16, 1998, except for
amounts paid or accrued pursuant to arrangements entered into before
January 16, 1998, and not substantially modified (including, for
example, by expansion of the arrangement (whether by exercise of an
option or otherwise) such as by an increase in the amount of or term of
any borrowing, leasing or licensing constituting the arrangement,
changes in direct or indirect control of any entity that is a party to
the arrangement, or any similar measure which materially increases the
tax benefit of the arrangement) on or after January 16, 1998.
(b) through (h) [Reserved]. For further guidance, see Sec. 1.954-
2(b) through (h).
Par. 8. Section 1.954-9T is added to read as follows:
Sec. 1.954-9T Hybrid branches (temporary).
(a) Subpart F income arising from certain payments involving hybrid
branches--(1) Payment causing foreign tax reduction gives rise to
additional subpart F income. The non-subpart F income of the controlled
foreign corporation will be recharacterized as subpart F income, to the
extent provided in paragraph (a)(5) of this section, if--
(i) A hybrid branch payment, as defined in paragraph (a)(6) of this
section, is made between the entities described in paragraph (a)(2) of
this section;
(ii) The hybrid branch payment reduces foreign tax, as determined
under paragraph (a)(3) of this section; and
(iii) The hybrid branch payment is treated as falling within a
category of foreign personal holding company income under the rules of
paragraph (a)(4) of this section.
(2) Hybrid branch payment between certain entities--(i) In general.
Paragraph (a)(1) of this section shall apply to hybrid branch payments
between--
(A) A controlled foreign corporation and its hybrid branch;
(B) Hybrid branches of a controlled foreign corporation;
(C) A partnership in which a controlled foreign corporation is a
partner (either directly or through one or more branches or other
partnerships) and a hybrid branch of the partnership; or
(D) Hybrid branches of a partnership in which a controlled foreign
corporation is a partner (either directly or through one or more
branches or other partnerships).
(ii) Hybrid branch payment involving partnership--(A) Fiscally
transparent partnership. To the extent of the controlled foreign
corporation's proportionate share of a hybrid branch payment, the rules
of paragraphs (a)(3), (4) and (5) of this section shall be applied by
treating the hybrid branch payment between the partnership and the
hybrid branch as if it were made directly between the controlled
foreign corporation and the hybrid branch, or as if the hybrid branches
of the partnership were hybrid branches of the controlled foreign
corporation, if the hybrid branch payment is made between--
(1) A fiscally transparent partnership in which a controlled
foreign corporation is a partner (either directly or through one or
more branches or other fiscally transparent partnerships) and the
partnership's hybrid branch; or
(2) Hybrid branches of a fiscally transparent partnership in which
a controlled foreign corporation is a partner (either directly or
through one or more branches or other fiscally transparent
partnerships).
(B) Non-fiscally transparent partnership. To the extent of the
controlled foreign corporation's proportionate share of a hybrid branch
payment, the rules of paragraphs (a)(3) and (4) and (a)(5)(iv) of this
section shall be applied to the non-fiscally transparent partnership as
if it were the controlled foreign corporation, if the hybrid branch
payment is made between--
(1) A non-fiscally transparent partnership in which a controlled
foreign corporation is a partner (either directly or through one or
more branches or other partnerships) and the partnership's hybrid
branch; or
(2) Hybrid branches of a non-fiscally transparent partnership in
which a controlled foreign corporation is a partner (either directly or
through one or more branches or other partnerships).
(C) Examples. The following examples illustrate the application of
this paragraph (a)(2)(ii).
Example 1. CFC, a controlled foreign corporation in Country A,
is a 90 percent partner in partnership P, which is treated as
fiscally transparent under the laws of Country A. P has a hybrid
branch, BR, in Country B. P makes an interest payment of $100 to BR.
Under Country A law, CFC's 90 percent share of the payment reduces
CFC's Country A income tax. Under paragraph (a)(2)(ii)(A) of this
section, the recharacterization rules of this section are applied by
treating the payment as if made by CFC to BR. Ninety dollars of
CFC's non-subpart F income, to the extent available, and subject to
the earnings and profits and tax rate limitations of Sec. 1.954-
9T(a)(5), is recharacterized as subpart F income.
Example 2. CFC, a controlled foreign corporation in Country A,
is a 90 percent partner in partnership P, which is treated as
fiscally transparent under the laws of Country A. P has two branches
in Country B, BR1 and BR2. BR1 is treated as fiscally transparent
under the laws of Country A. BR2 is a hybrid branch. BR1 makes an
interest payment of $100 to BR2. Under paragraph (a)(2)(ii)(A) of
this section, the payment by BR1, the fiscally transparent branch,
is treated as a payment by P, and the deemed payment by P, a
fiscally transparent partnership, is treated as made by CFC. Under
Country A law, CFC's 90 percent share of BR1's payment reduces CFC's
Country A income tax. Ninety dollars of CFC's non-subpart F income,
to the extent available, and subject to the earnings and profits and
tax rate limitations of Sec. 1.954-9T(a)(5), is recharacterized as
subpart F income.
(3) Application when payment reduces foreign tax. For purposes of
paragraph (a)(1) of this section, a hybrid branch payment reduces
foreign tax when the foreign tax imposed on the
[[Page 14618]]
income of the payor or any owner of the payor is less than the foreign
tax that would have been imposed on such income had the hybrid branch
payment not been made, or the hybrid branch payment creates or
increases a loss or deficit or other tax attribute which may be carried
back or forward to reduce the foreign income tax of the payor or any
owner in another year (determined by taking into account any refund of
such tax made to the payor, payee or any other person).
(4) Hybrid branch payment that is included within a category of
foreign personal holding company income--(i) In general. For purposes
of paragraph (a)(1) of this section, whether the hybrid branch payment
is treated as income included within a category of foreign personal
holding company income is determined by treating a hybrid branch that
is either the payor or recipient of the hybrid branch payment as a
separate wholly-owned subsidiary corporation of the controlled foreign
corporation that is incorporated in the jurisdiction under the laws of
which such hybrid branch is created, organized for foreign law
purposes, or has substantial assets. Thus, the hybrid branch payment
will be treated as included within a category of foreign personal
holding company income if, taking into account any specific exceptions
for that category, the payment would be included within a category of
foreign personal holding company income if the branch or branches were
treated as separately incorporated for U.S. tax purposes.
(ii) Extent to which controlled foreign corporation and hybrid
branches treated as separate entities. For purposes other than the
determination under paragraph (a)(4)(i) of this section, a controlled
foreign corporation and its hybrid branch, a partnership and its hybrid
branch, or hybrid branches shall not be treated as separate entities.
Thus, for example, if a controlled foreign corporation, including all
of its hybrid branches, has an overall deficit in earnings and profits
to which section 952(c) applies, the limitation of such section on the
amount includible in the subpart F income of such corporation will
apply. Similarly, for purposes of applying the de minimis and full
inclusion rules of section 954(b)(3), a controlled foreign corporation
and its hybrid branch, or hybrid branches shall not be treated as
separate corporations. Further, a hybrid branch payment that would
reduce foreign personal holding company income under section 954(b)(5)
if made between two separate entities will not create an expense if
made between a controlled foreign corporation and its hybrid branch, a
partnership and its hybrid branch, or hybrid branches.
(5) Recharacterization of income attributable to current earnings
and profits as subpart F income--(i) General rule. Non-subpart F income
of a controlled foreign corporation in an amount equal to the excess of
earnings and profits of the controlled foreign corporation for the
taxable year over subpart F income, as defined in section 952(a), will
be recharacterized as subpart F income under paragraph (a)(1) of this
section only to the extent provided under paragraphs (a)(5)(ii) through
(vi) of this section.
(ii) Subpart F income. For purposes of determining the excess of
current earnings and profits over subpart F income under paragraph
(a)(1) of this section, the amount of subpart F income is determined
before the application of the rules of this section but after the
application of the rules of sections 952(c) and 954(b). Further, such
amount is determined by treating the controlled foreign corporation and
all of its hybrid branches as a single corporation.
(iii) Recharacterization limited to gross amount of hybrid branch
payment--(A) In general. The amount recharacterized as subpart F income
under paragraph (a)(1) of this section is limited to the amount of the
hybrid branch payment.
(B) Exception for duplicative payments. [Reserved].
(iv) Tax disparity rule--(A) In general. Paragraph (a)(1) of this
section will apply only if the hybrid branch payment falls within the
tax disparity rule. The hybrid branch payment falls within the tax
disparity rule if it is taxed in the year when earned at an effective
rate of tax that is less than 90 percent of, and at least 5 percentage
points less than, the hypothetical effective rate of tax imposed on the
hybrid branch payment, as determined under paragraph (a)(5)(iv)(B) of
this section.
(B) Hypothetical effective rate of tax--(1) In general. The
hypothetical effective rate of tax imposed on the hybrid branch payment
is--
(i) For the taxable year of the payor in which the hybrid branch
payment is made, the amount of income taxes that would have been paid
or accrued by the payor if the hybrid branch payment had not been made,
less the amount of income taxes paid or accrued by the payor; divided
by
(ii) The amount of the hybrid branch payment.
(2) Hypothetical effective rate of tax when hybrid branch payment
causes or increases loss or deficit. If the hybrid branch payment
causes or increases a loss or deficit of the payor for foreign tax
purposes, and such loss or deficit can be carried forward or back, the
hypothetical effective rate of tax imposed on the hybrid branch payment
is the effective rate of tax that would be imposed on the taxable
income of the payor for the year in which the foreign law payment is
made if the payor's taxable income were equal to the amount of the
hybrid branch payment.
(C) Examples. The application of this paragraph (a)(5)(iv) is
illustrated by the following examples.
Example 1. In 1998, CFC organized in Country A had net income of
$60 from manufacturing for Country A tax purposes. It also had a
branch (BR) in Country B. BR is a hybrid entity under paragraph
(a)(1) of this section. CFC made a payment of $40 to BR, which was a
hybrid branch payment under paragraph (a)(6) of this section, and
was treated by CFC as a deductible payment for Country A tax
purposes. CFC paid $30 of Country A taxes in 1998. It would have
paid $50 of Country A taxes without the deductible payment. Country
A did not impose any withholding tax on the $40 payment to BR.
Country B also did not impose a tax on the $40 received by BR.
Therefore, the effective rate of tax on that payment is 0%.
Furthermore, the hypothetical effective rate of tax on the $40
hybrid branch payment is 50% ($50-$30/$40). The effective rate of
tax (0%) is less than 90% of, and more than 5 percentage points less
than, this hypothetical rate of tax of 50%. As a result, the $40
hybrid branch payment falls within the tax disparity rule of this
paragraph (a)(5)(iv).
Example 2. Assume the same facts as in Example 1, except that
CFC has a loss of $100 for the year for Country A tax purposes.
Under Country A law, CFC can carry the loss forward for use in
subsequent years. CFC paid no Country A taxes in 1998. The rate of
tax in Country A is graduated from 20% to 50%. If the $40 hybrid
branch payment were the only item of taxable income of CFC, Country
A would have imposed tax at an effective rate of 30%. The effective
rate of tax (0%) is less than 90 percent of, and more than 5
percentage points less than, the hypothetical effective rate of tax
(30%) imposed on the hybrid branch payment. As a result, the $40
hybrid branch payment falls within the tax disparity rule of this
paragraph (a)(5)(iv).
Example 3. Assume the same facts as in Example 1, except that
Country B imposes tax on the $40 hybrid payment to BR at an
effective rate of 50%. The effective rate of 50% is equal to the
hypothetical effective rate of tax. As a result, the hybrid branch
payment does not fall within the tax disparity rule of this
paragraph (a)(5)(iv) and, thus, the recharacterization rules of
paragraph (a)(1) of this section do not apply. See also the special
high tax exception of paragraph (a)(5)(v) of this section.
(v) Special high tax exception--(A) In general. Paragraph (a)(1) of
this section shall not apply if the non-subpart F income
recharacterized as subpart F
[[Page 14619]]
income under this section was subject to foreign income taxes imposed
by a foreign country or countries at an effective rate that is greater
than 90 percent of the maximum rate of tax specified in section 11 for
the taxable year of the controlled foreign corporation.
(B) Effective rate of tax. The effective rate of tax imposed on the
net amount of the hybrid branch payment is determined under the
principles of Sec. 1.954-1(d)(2) and (3). See paragraph (c) of this
section for the application of section 960 to amounts recharacterized
as subpart F income under this section.
(vi) No carryback or carryforward of amounts in excess of current
year earnings and profits limitation. To the extent that some or all of
the amount required to be recharacterized under this section is not
recharacterized as subpart F income because the hybrid branch payment
exceeds the amount that can be recharacterized, as determined under
paragraph (a)(5)(i) of this section, this excess shall not be carried
back or forward to another year.
(6) Definitions. For purposes of this section--
Entity means any person that is treated by the United States or any
jurisdiction as other than an individual.
Hybrid branch means an entity that--
(i) Has a single owner (including ownership through branches) that
is either a controlled foreign corporation or a partnership in which a
controlled foreign corporation is a partner (either directly or
indirectly through one or more branches or partnerships);
(ii) Is treated as fiscally transparent by the United States; and
(iii) Is treated as non-fiscally transparent by the country in
which the payor entity, any owner of a fiscally-transparent payor
entity, the controlled foreign corporation, or any intermediary
partnership is created, organized or has substantial assets.
Hybrid branch payment means the gross amount of any payment
(including any accrual) which, under the tax laws of any foreign
jurisdiction to which the payor is subject, is regarded as a payment
between two separate entities but which, under U.S. income tax
principles, is not income to the recipient because it is between two
parts of a single entity.
(7) Fiscally transparent and non-fiscally transparent. For purposes
of this section an entity shall be treated as fiscally transparent with
respect to an interest holder of the entity, if such interest holder is
required, under the laws of any jurisdiction to which it is subject, to
take into account separately, on a current basis, such interest
holder's share of all items which, if separately taken into account by
such interest holder, would result in an income tax liability for the
interest holder in such jurisdiction different from that which would
result if the interest holder did not take the share of such items into
account separately. A non-fiscally transparent entity is an entity that
is not fiscally transparent under this paragraph (a)(7).
(b) Election to change classification--(1) In general. If a hybrid
branch subject to the provisions of paragraph (a) of this section is an
entity that has made an election under Sec. 301.7701-3(c)(1) of this
chapter to be disregarded as an entity separate from its owner, such
entity may elect to change its classification to that of an association
taxable as a corporation, under the procedures described in
Sec. 301.7701-3(c) of this chapter, without regard to the limitation of
Sec. 301.7701-3T(c)(1)(iv) of this chapter, but only if such election
is made on or before the last day of the first taxable year beginning
on or after January 1, 1998. An election made pursuant to this
paragraph (b)(1) is effective as of the first day of such taxable year.
The 75 day limitation on retroactivity in Sec. 301.7701-3(c)(1)(iii) of
this chapter does not apply.
(2) Limitation. An entity can elect to change its classification
under the provisions of this paragraph only one time.
(c) Application of section 960--For purposes of determining the
amount of taxes deemed paid under section 960, the amount of non-
subpart F income recharacterized as subpart F income under this section
shall be treated as attributable to income in separate categories, as
defined in Sec. 1.904-5(a)(1), in proportion to the ratio of non-
subpart F income in each such category to the total amount of non-
subpart F income of the controlled foreign corporation for the taxable
year.
(d) Effective dates--(1) Hybrid branches of controlled foreign
corporations. With respect to hybrid branch payments described in
paragraph (a)(2)(i)(A) and (B) of this section, the rules of this
section shall apply to all amounts paid or accrued on or after January
16, 1998, except for amounts paid or accrued pursuant to arrangements
entered into before January 16, 1998, and not substantially modified
(including, for example, by expansion of the arrangement (whether by
exercise of an option or otherwise) such as by an increase in the
amount of or term of any borrowing, leasing or licensing constituting
the arrangement, changes in direct or indirect control of any entity
that is a party to the arrangement, or any similar measure which
materially increases the tax benefit of the arrangement) on or after
January 16, 1998.
(2) Hybrid branches of partnerships in which controlled foreign
corporations are partners. With respect to hybrid branch payments
described in paragraph (a)(2)(i)(C) and (D) of this section, the rules
of this section shall apply to all amounts paid or accrued on or after
March 23, 1998, except for amounts paid or accrued pursuant to
arrangements entered into before March 23, 1998 and not substantially
modified (including, for example, by expansion of the arrangement
(whether by exercise of an option or otherwise) such as by an increase
in the amount of or term of any borrowing, leasing or licensing
constituting the arrangement, changes in direct or indirect control of
any entity that is a party to the arrangement, or any similar measure
which materially increases the tax benefit of the arrangement) on or
after March 23, 1998.
PART 301--PROCEDURE AND ADMINISTRATION
Par. 9. The authority citation for 26 CFR part 301 continue to read
in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 10. In Sec. 301.7701-3, paragraph (f)(1) is amended by adding
a sentence at the end to read as follows:
Sec. 301.7701-3. Classification of certain business entities.
* * * * *
(f)(1) * * * Paragraphs (a), (c)(1)(iv) and (f) of this section do
not apply on or after March 23, 1998. For rules applicable on or after
March 23, 1998, see Sec. 301.7701-3T(a), (c)(1)(iv) and (f).
Par. 11. Section 301.7701-3T is added to read as follows:
Sec. 301.7701-3T Classification of certain business entities
(temporary).
(a) In general. A business entity that is not classified as
corporation under Sec. 301.7701-2(b)(1), (3), (4), (5), (6), (7), or
(8) (an eligible entity) can elect its classification for federal tax
purposes as provided in this section. An eligible entity with at least
two members can elect to be classified as either an association (and
thus a corporation under Sec. 301.7701-2(b)(2)) or a partnership, and
an eligible entity with a single owner can elect to be classified as an
association or to be disregarded as an entity separate from its owner.
Paragraph (b) of this section provides a default classification for an
eligible entity that does not make an election.
[[Page 14620]]
Thus, elections are necessary only when an eligible entity chooses to
be classified initially as other than the default classification or
when an eligible entity chooses to change its classification. An entity
whose classification is determined under the default classification
retains that classification (regardless of any changes in the members'
liability that occurs at any time during the time that the entity's
classification is relevant as defined in paragraph (d) of this section)
until the entity makes an election to change that classification under
paragraph (c)(1) of this section. Paragraph (c) of this section
provides rules for making express elections. Paragraph (d) provides
special rules for foreign eligible entities. Paragraph (e) of this
section provides special rules for classifying entities resulting from
partnership terminations and divisions under section 708(b). Paragraph
(f) of this section sets forth the effective date of this section and a
special rule relating to prior periods. An entity that has elected to
be disregarded as an entity separate from its owner may nevertheless be
treated as a corporation for the limited purposes of Sec. 1.954-
9T(a)(4)(i) of this chapter.
(b) through (c)(1)(iii) [Reserved]. For further guidance, see
Sec. 301.7701-3(b) through (c)(1)(iii).
(c)(1)(iv) Limitation. If an eligible entity makes an election
under paragraph (c)(1)(i) of this section to change its classification
(other than an election made by an existing entity to change its
classification as of the effective date of this section), the entity
cannot change its classification by election again during the sixty
months succeeding the effective date of the election. However, the
Commissioner may permit the entity to change its classification by
election within the sixty months if more than fifty percent of the
ownership interests in the entity as of the effective date of the
subsequent election are owned by person that did not own any interests
in the entity on the filing date or on the effective date of the
entity's prior election. See Sec. 1.954-9T(b) of this chapter, for
circumstances under which certain eligible entities may make an
election to change their classification within the sixty-month period.
(c)(1)(v) through (e) [Reserved]. For further guidance, see
Sec. 301.7701-3(c)(1)(v) through (e).
(f) Effective date. Section 301.7701-3T(a) and (c)(1)(iv) applies
on or after March 23, 1998. For rules prior to March 23, 1998, see
Sec. 301.7701-3(a) and (c)(1)(iv).
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
Approved:
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 98-7891 Filed 3-23-98; 12:58 pm]
BILLING CODE 4830-01-U
