Generally, these two tax benefits are not treated similarly to, for example, depreciation deductions or net operating losses under IRC §267A. They will be considered as part of hybrid tax planning that is not permitted under the Code.
However, there are exceptions in certain hybrid transactions when a party uses one of these two benefits.
This post explores examples on how participation exemptions are treated under the final IRS §267A regulations. Similar principles apply for dividend received deductions and other types of dividend relief.
Code Section 267A: The Basics
IRC §267A disallows for hybrid payments of interest or royalties made by related parties, also known as the disallowance rule. A hybrid payment is a payment:
- made on a hybrid instrument; or
- involves a related hybrid entity, such as a taxable branch.
When a taxpayer gets a deduction under U.S. tax law for an interest or royalty payment, but the recipient does not include that payment in its income, the tax result is called a deduction/no-inclusion (D/NI) outcome.
General Rule for Participation Exemptions
- it is not included in the income of a tax resident or taxable branch; and
- is not income due to a participation exemption or other relief for dividends.
In other words, U.S. tax law kicks in requiring a recognition of income because the income amount would otherwise avoid taxation twice.
As a result, the income subject to the participation exemption or dividend relief deduction is:
- dual inclusion income; and
- not treated as exempt in the payment transaction.
This rule applies whether the participation exemption or dividends received deduction is offered under U.S. or foreign tax law.
Example of Dual Inclusion Income
FX is a corporation in Country X. It wholly owns 100% of a US1, a U.S. taxable branch which is disregarded under Country X law.
FX issues an instrument to US1 that is treated as equity under Country X law. However, U.S. law treats the instrument as debt. It is, under IRC §267A, a hybrid instrument.
US1 makes a $100 interest payment to FX on the instrument. The interest payment is deductible by US1.
FX receives no payments under Country X law because US1 is a disregarded entity.
The payment is a disregarded payment because FX and US1 are a single taxpayer under Country X law.
During the tax year, US1’s has $125 of gross income and a $60 item of deductible expense. The $125x item of gross income is included in FX’s income, and the $60x item of deductible expense is allowable for Country X tax purposes.
US1 has $65 of dual inclusion income, $125 income less $60 expense. The $100 disregarded payment less the $65 dual inclusion income, leaves $35.
$35 is the disqualified hybrid amount under the disregarded payment rule.
It is the amount of the payment that avoids tax at both the US and the Country X levels.
Exception for Participation Exemptions in Hybrid Transactions
However, sometimes a participation exemption, a DRD, or other relief may avoid double-taxation in a corporate structure where a hybrid payment is made.
Example of No Dual Inclusion Income
Consider that US1 wholly owns FZ, a corporation organized in Country Z. FZ is a controlled foreign corporation (CFC) under U.S. tax law. However, from a Country X perspective, FX wholly owns FZ because US1 is disregarded.
US1 and FZ have entered a debt instrument, the US1-FZ instrument under which FZ makes an $80 payment of interest to US1.
Both the United States and Country Z treat the instrument as debt. Country X treats the US1-FZ instrument as equity. Because it is equity under Country X, the $80 payment is a dividend from FZ to FX.
US1’s only item of income or deduction, other than the $100 payment to FX, is the $80 received from FZ.
The $80 is treated as interest for Country Z and U.S. tax purposes. Country X treats the total amount as a dividend subject to Country X’s participation exemption.
The hybrid transaction rule of §1.267A-2(a) applies to FZ’s payment. The payment is made in a hybrid transaction as the US1-FZ instrument is treated as interest under U.S. law but not under Country X tax law. In addition, FX is a specified recipient related to FZ.
Due to the participation exemption, an $80 no inclusion occurs for FX. But a “no inclusion” does not occur in the interest payment transaction between FZ and US1. Thus, the transaction does not result in a double no income inclusion, D/NI.
Because US1 takes the $80 into income, the payment is not a disqualified hybrid amount subject to the disallowance rule. See §1.267A-3(b)(2).
Participation Exemption and Relief from Double Taxation
This second example shows that the general rule for participation exemptions does not hold when the exemption relieves double taxation.
FZ’s $80 payment is a dividend for Country X purposes. However, the payment is also interest for US1 and that payment is considered received by FX under Country X law. The participation exemption prevents FX from taking the $80 into income twice.
Tax Planning in Hybrid Transactions
Participation exemptions and DRDs will cause a hybrid payment to become a disregarded payment, in whole or in part where:
- there is dual inclusion income; and
- a deduction taken by a related party.
Final IRC §267A regulations issued by the U.S. Treasury Department address these transactions.
The regulations also include an exception where a participation exemption causes relief from double taxation in a hybrid transaction.
Taxpayers and tax planners don’t need to avoid participation exemptions altogether when planning transactions in hybrid structures. They just need to ensure the participation exemption is not causing a dual no income inclusion.
By Lisa Lopata, J.D.