[Federal Register Volume 64, Number 133 (Tuesday, July 13, 1999)]
[Proposed Rules]
[Pages 37727-37733]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-17367]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 301
[REG-113909-98]
RIN 1545-AW63
Withdrawal of Guidance Under Subpart F Relating to Partnerships
and Branches and Issuance of New Guidance Under Subpart F Relating to
Certain Hybrid Transactions
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Withdrawal; Notice of proposed rulemaking; and notice of public
hearing.
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SUMMARY: This document withdraws the notice of proposed rulemaking and
notice of proposed rulemaking by cross-reference to temporary
regulations that was published in the Federal Register on March 26,
1998, providing guidance under subpart F relating to partnerships and
branches. This document contains new proposed regulations relating to
the treatment under subpart F of certain transactions involving hybrid
branches. These regulations are necessary to provide guidance on
transactions relating to such entities. This document also provides
notice of a public hearing on these proposed regulations.
DATES: Written comments, and outlines of oral comments to be discussed
at the public hearing scheduled for December 1, 1999, must be received
by November 10, 1999.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-113909-98), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
113909-98), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington DC. Alternatively, taxpayers may submit
comments electronically via the Internet by selecting the ``Tax Regs''
option on the IRS Home Page, or by submitting comments directly to the
IRS Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
regslist.html. The public hearing will be held in room 2615, Internal
Revenue Building, 1111 Constitution Avenue NW., Washington, DC 20224.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Valerie
Mark, (202) 622-3840; concerning submissions of comments, the hearing,
and/or to be placed on the building access list to attend the hearing,
LaNita Van Dyke (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
On March 23, 1998 (63 FR 14669, March 26, 1998), the IRS issued
proposed regulations (REG-104537-97) relating to the treatment under
subpart F of certain partnership and hybrid branch transactions. The
provisions of the proposed regulations relating to hybrid branch
transactions were also issued as temporary regulations (TD 8767) (63 FR
14613, March 26, 1998). Certain members of Congress and taxpayers
raised concerns about the proposed and temporary regulations relating
to hybrid branch transactions. On June 19, 1998, the Treasury announced
in Notice 98-35 (1998-27 I.R.B. 35) that the temporary regulations
would be removed and that the proposed regulations relating to hybrid
transactions would be re-proposed with new dates of applicability to
give Congress the opportunity to consider in greater depth the issues
raised by hybrid transactions.
As provided in Notice 98-35, these proposed regulations
substantially restate the regulations relating to hybrid transactions
issued in March of 1998. These proposed regulations, however, contain
certain clarifications requested by taxpayers. Further, as described in
greater detail below, unlike the effective date rules announced in
Notice 98-35, these regulations are proposed to be effective only for
payments made in taxable years commencing after the date that is five
years after the date of finalization of these regulations. The
permanent grandfather relief described in Notice 98-35 remains
unchanged.
These proposed regulations represent the IRS and Treasury's views
of how current law should be enforced. Treasury is currently
undertaking a comprehensive study of subpart F. These proposed
regulations will not control the results of the study. For example, an
objective analysis of the policies and goals of subpart F may lead to
the conclusion that subpart F should be significantly restructured.
To the extent, however, that Congress does not restructure subpart
F in a manner that would alter the rules enforced by these regulations,
Treasury and the IRS believe that these regulations will be necessary
to preserve the integrity of the current statutory scheme. The use of
hybrid arrangements, which is greatly facilitated by the ``check-the-
box'' entity classification regulations (Secs. 301.7701-1 through
301.7701-3), would otherwise give rise to the following inconsistency:
if sales income is shifted from one CFC to a related CFC in a different
jurisdiction, subpart F income may arise; if sales income is shifted
from one CFC to its branch in a different jurisdiction, subpart F
income may arise; if income is shifted through interest payments from
one CFC to a related CFC in a different jurisdiction, subpart F income
may arise; however, if income is shifted through interest payments from
one CFC to its hybrid branch in a different jurisdiction, subpart F
income will not arise. This final result does not seem an appropriate
policy outcome within the framework of current subpart F, and is almost
certainly inconsistent with the Congressional intent underlying the
rules being interpreted here.
Treasury anticipates that taxpayers will comment both on the
appropriateness of these proposed regulations under current law, and on
the contents of its subpart F study, including any conclusions that the
study might draw about potential changes to subpart F. To allow proper
time to consider all these issues, Treasury and the IRS have
significantly modified and liberalized the effective date rules set
forth in Notice 98-35. New regulations regarding the treatment of a
controlled foreign corporation's distributive share of partnership
income will be proposed at a later date.
Explanation of Provisions
I. In General
In these proposed regulations, Treasury and the IRS set forth a
framework for dealing with issues arising under subpart F (sections 951
through 964) that relate to the use of certain entities that are
regarded as fiscally transparent for purposes of U.S. tax law.
II. Hybrid Branches
Treasury and the IRS understand that certain taxpayers are using
arrangements involving hybrid branches
[[Page 37728]]
to circumvent the purposes of subpart F. 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.
Under these proposed 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 payment had
been taxed in the hands of the payor.
The proposed regulations would 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. 1.954-9(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, would not be treated as
separate corporations.
The proposed regulations would 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 proposed 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.
The proposed regulations would 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.
The proposed regulations would 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).
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.
III. Related Provisions
These proposed regulations would provide rules, contained in
Sec. 1.954-1(c)(1)(i)(B), to prevent expenses, including related person
interest expense that 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 between the CFC
and 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 proposed regulations also would 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 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.
Under these proposed regulations, if the partnership receives an
item of income that reduces the foreign income tax of the payor, the
related person exceptions of section 954(c)(3) would 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.
In addition, these proposed regulations contain rules that would
apply the related person exceptions to certain payments involving
hybrid branches. These rules would apply to payments by a CFC to a
hybrid branch of a related CFC. Under these rules, the related person
exceptions would 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).
[[Page 37729]]
IV. Request for Comments
Comments on policy issues that relate to subpart F and deferral,
generally, including comments on legislative modifications to the
current rules, and comments solicited on the broad policy issues
mentioned in Notice 98-35, can be submitted in response to the study
mentioned above. Treasury and the IRS invite comments on the
appropriateness of these regulations under the current subpart F rules.
Proposed Effective Date
These proposed regulations will not be finalized before July 1,
2000. It is proposed that, when finalized, these regulations would be
effective only for payments made in taxable years of a controlled
foreign corporation commencing after the date that is five years after
the date of finalization of these regulations. These regulations would
not, however, apply to any payments made under hybrid arrangements
entered into before June 19, 1998. This exception is permanent so long
as the arrangement is not substantially modified on or after June 19,
1998. An illustrative list of events that would and would not
constitute ``substantial modification'' of an arrangement is included
in these regulations.
Special Analyses
It has been determined that this notice of proposed rulemaking 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, this notice of proposed rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment
on its impact on small business.
Request for Comments
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. The IRS and
Treasury specifically request comments on the clarity of these proposed
regulations and how they may be made easier to understand. All comments
will be available for public inspection and copying.
A public hearing has been scheduled for December 1, 1999, at 10
a.m., in room 2615, Internal Revenue Building, 1111 Constitution Avenue
NW., Washington DC. Due to building security procedures, visitors must
enter at the 10th Street entrance, located between Constitution and
Pennsylvania Avenues, NW. In addition, all visitors must present photo
identification to enter the building. Because of access restrictions,
visitors will not be admitted beyond the immediate entrance area more
than 15 minutes before the hearing starts. For information about having
your name placed on the building access list to attend the hearing, see
the FOR FURTHER INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments and an outline of topics to be discussed and
time to be devoted to each topic (signed original and eight (8) copies)
by November 10, 1999.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
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 in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Withdrawal of Notice of Proposed Rulemaking and Proposed Amendments
to the Regulations
Accordingly, under the authority of 26 U.S.C. 7805, the notice of
proposed rulemaking amending 26 CFR parts 1 and 301 that was published
in the Federal Register on March 26, 1998, 63 FR 14669 (REG-104537-97),
is withdrawn. In addition, 26 CFR part 1 is proposed to be 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 (k)(1) is revised to read as
follows:
Sec. 1.904-5 Look-through rules as applied to controlled foreign
corporations and other entities.
* * * * *
(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. 1.954-1(c)(1)(i) will apply to any
expense subject to Sec. 1.954-1(c)(1)(i).
* * * * *
Par. 3. Section 1.954-0 (b) is amended as follows:
1. The entry for Sec. 1.954-1(c)(1)(i) is revised.
2. Entries for Sec. 1.954-1(c)(1)(i)(A) through (c)(1)(i)(E) are
added.
3. An entry for Sec. 1.954-2(a)(5) is added.
4. An entry for Sec. 1.954-2(a)(6) is added.
The revision and additions read as follows:
Sec. 954-0 Introduction.
* * * * *
(b) * * *
Section 1.954-1 Foreign Base Company Income
* * * * *
(c) * * *
(1) * * *
(i) Deductions.
(A) Deductions against gross foreign base company income.
(B) Special rule for deductible payments to certain non-fiscally
transparent entities.
(C) Limitations.
(D) Example.
(E) Effective date.
* * * * *
Section 1.954-2 Foreign Personal Holding Company Income
(a) * * *
(5) Special rules applicable to distributive share of
partnership income.
(i) Application of related person exceptions where payment
reduces foreign tax of payor.
(ii) Certain other exceptions applicable to foreign personal
holding company income. [Reserved]
(iii) Effective date.
(6) Special rules applicable to exceptions from foreign personal
holding company income treatment in circumstances involving hybrid
branches.
(i) In general.
[[Page 37730]]
(ii) Exception where no tax reduction or tax disparity.
(iii) Effective date.
* * * * *
Par. 4. Section 1.954-1 is amended as follows:
1. Paragraphs (c)(1)(i) heading and introductory text and
(c)(1)(i)(A) through (c)(1)(i)(D) are redesignated as paragraphs
(c)(1)(i)(A) heading and introductory text and (c)(1)(i)(A)(1) through
(c)(1)(i)(A)(4), respectively.
2. A heading for paragraph (c)(1)(i) is added.
3. Paragraphs (c)(1)(i)(B) through (c)(1))(i)(E) are added.
The additions read as follows:
Sec. 1.954-1 Foreign base company income.
* * * * *
(c) * * *
(1) * * *
(i) Deductions--(A) Deductions against gross foreign base company
income. * * *
(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. 1.954-9(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 reduced
foreign tax, under Sec. 1.954-9(a)(3), and would have fallen within the
tax disparity rule of Sec. 1.954-9(a)(5)(iv), if those provisions had
been applicable to the payment.
(C) Limitations. Paragraph (c)(1)(i)(B) of this section 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
paragraphs (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. 1.954-9 to apply if the
payment were made between the entities described in Sec. 1.954-
9(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 be applicable for all payments made or accrued in taxable
years commencing after [date that is 5 years after publication of the
final regulations in the Federal Register], under hybrid arrangements,
unless such payments are made pursuant to an arrangement that would
qualify for permanent relief under Sec. 1.954-9(c)(2) if made between a
controlled foreign corporation and its hybrid branch, in which case the
relief afforded under that section shall also be afforded under this
section.
* * * * *
Par. 5. In Sec. 1.954-2, paragraphs (a)(5) and (a)(6) are added to
read as follows:
Sec. 1.954-2 Foreign personal holding company income.
(a) * * *
(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. 1.954-9(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 paragraph (b)(4) of
this section);
(2) The partnership is regarded as fiscally transparent, as defined
in Sec. 1.954-9(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 in taxable years commencing after
[date that is 5 years after publication of the final regulations in the
Federal Register], under hybrid arrangements, unless such payments are
made pursuant to an arrangement which would qualify for permanent
relief under Sec. 1.954-9(c)(2) if made between a controlled foreign
corporation and its hybrid branch, in which case the relief afforded
under that section shall also be afforded under this section.
(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
[[Page 37731]]
defined in Sec. 1.954-9(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
reduced foreign tax, under Sec. 1.954-9(a)(3), and fallen within the
tax disparity rule of Sec. 1.954-9(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 in taxable years commencing after [date that is
5 years after publication of the final regulations in the Federal
Register], under hybrid arrangements, unless such payments are made
pursuant to an arrangement which would qualify for permanent relief
under Sec. 1.954-9(c)(2) if made between a controlled foreign
corporation and its hybrid branch, in which case the relief afforded
under that section shall also be afforded under this section.
Par. 6. Section 1.954-9 is added to read as follows:
Sec. 1.954-9 Hybrid branches.
(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 a 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 paragraph
(a)(5) of this section, 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 paragraph (a)(5) of this section, 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 income of the payor, or
any person that is a related person with respect to the payor (as
determined under the principles of section 954(d)(3)), 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
[[Page 37732]]
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 of this section,
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 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 2006, 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 2006. 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 2006. 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% 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 that would be
recharacterized as subpart F 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
non-subpart F income that would be recharacterized as subpart F income
under this section is determined under the principles of Sec. 1.954-
1(d)(2) and (3). See paragraph (b) 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
[[Page 37733]]
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 this section. For purposes of this section:
(i) Arrangement shall mean any agreement to pay interest, rents,
royalties or similar amounts. It shall also include the declaration and
payment of a dividend (but not an agreement or undertaking to pay
future, unspecified dividends). An arrangement shall not, however,
include the mere formation or acquisition (or similar event) of a
hybrid branch that is intended to become a party to an arrangement.
(ii) Entity means any person that is treated by the United States
or any jurisdiction as other than an individual.
(iii) Hybrid branch means an entity that--
(A) Is disregarded as an entity separate from its owner for federal
tax purposes and is owned (including ownership through branches) by
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);
(B) Is treated as fiscally transparent by the United States; and
(C) 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.
(iv) 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) 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.
(c) Effective dates--(1) In general. This section shall be
applicable for all amounts paid or accrued in taxable years commencing
after [date that is 5 years after publication of the final regulations
in the Federal Register], under hybrid arrangements, except as
otherwise provided.
(2) Permanent Relief--(i) In general. This section shall not apply
to any payments made under hybrid arrangements entered into before June
19, 1998. This exception shall be permanent so long as the arrangement
is not substantially modified, within the meaning of paragraph
(c)(2)(ii) of this section, on or after June 19, 1998.
(ii) Substantial modification--(A) In general. Substantial
modification of a hybrid arrangement includes--
(1) The expansion of the hybrid arrangement (other than de minimis
expansion);
(2) A more than 50% change in the U.S. ownership (direct or
indirect) of any entity that is a party to the hybrid arrangement,
other than--
(i) A transfer of ownership of such party within a controlled group
determined under section 1563(a), without regard to section 1563(a)(4);
or
(ii) A change in ownership of the entire controlled group
(determined under section 1563(a), without regard to section
1563(a)(4)) of which such party is a member;
(3) Any measure taken by a party to the arrangement (or any related
party) that materially increases the tax benefit of the hybrid
arrangement, regardless of whether such measure alters the legal
relationship between the parties to the arrangement. For example, in
the case of a hybrid branch payment determined with reference to a
percentage of sales, a growth in the amount of the hybrid branch
payment (and, thus, the tax benefit) caused by a growth of sales will
not, in general, be a substantial modification. However, in the case of
a significant sales growth resulting from a transfer of assets by a
related party, that transfer would be a measure which materially
increased the benefit of the arrangement, and that arrangement would be
deemed to have been substantially modified.
(B) Transactions not treated as substantial modification.
Substantial modification of a hybrid arrangement does not include--
(1) The daily reissuance of a demand loan by operation of law;
(2) The renewal of a loan, license or rental agreement on the same
terms and conditions if--
(i) The renewal occurs pursuant to the terms of the agreement and
without more than a de minimis amount of action of any party thereto;
(ii) As contemplated by the original agreement, the same parties
agree to renew the agreement without modification; or
(iii) The renewal occurs solely by reason of a subsequent drawdown
under a grandfathered master credit facility agreement;
(3) The renewal of a loan, license, or rental agreement by the same
parties on terms which do not increase the tax benefit of the
arrangement (other than a de minimis increase);
(4) The making of payments under a license agreement in respect of
copyrights or patents (or know-how associated with such copyrights or
patents), not in existence at the time the agreement was entered into,
but only where the development of such property was anticipated by the
agreement, and such property is substantially derived from (or
otherwise incorporates substantial features of) copyrights and patents
(or know-how associated with such copyrights or patents) in existence
at the time of, and covered under, the original agreement;
(5) A final transfer pricing adjustment made by the taxation
authorities of the jurisdiction in which the tax reduction occurs, so
long as such adjustment would not have been a substantial valuation
misstatement (as defined in section 6662(e)(1)(B)) if the adjustment
had been made by the Internal Revenue Service; or
(6) A de minimis periodic adjustment by the parties to the
arrangement made annually (or more frequently) to conform the payments
to the requirements of section 482.
Charles O. Rossotti,
Commissioner of Internal Revenue.
[FR Doc. 99-17367 Filed 7-12-99; 8:45 am]
BILLING CODE 4830-01-U
