IRC §267A disallows deductions for interest and royalties’ payments made to reverse hybrids if:
- no tax is paid in any country for the payment; and
- parties to the transaction are in the same corporate structure, i.e., “related parties.”
This rule in IRC §267A is called the “disallowance rule.” It applies when there are fiscally transparent entities in a transaction, such as a reverse hybrid.
An entity that is fiscally transparent is also known as a disregarded entity or a hybrid entity. It is disregarded as a taxable entity under:
- the law of one of its investors or owners; or
- its domestic tax law (not U.S. tax law).
This post covers some basic examples from the Treasury regulations that show how a payment to a reverse hybrid will result in a disallowed deduction under IRC §267A.
What is a Reverse Hybrid?
Treasury regulations under IRC §267A define “reverse hybrid.”
An IRC §267A reverse hybrid is an entity that is fiscally transparent under the tax law of the country where it was created or organized. However, it is not fiscally transparent under the tax law of the country that applies to an investor or owner.
This means that the local law treats income and loss items of the transparent entity as flowing through to the owner. However, the owner does not treat those items as if they flowed through to it.
A reverse hybrid, for IRC §267A purposes, can be domestic or foreign.
Example of a Reverse Hybrid
A U.S. corporation and its subsidiary corporation in Country X organize a subsidiary in Country Z. They own equal shares of the Country Z subsidiary.
Both shareholders treat the subsidiary as a corporate entity for U.S. tax purposes.
In contrast, that subsidiary is treated as a partnership under the tax law of Country Z.
The Country Z entity is a reverse hybrid.
A partnership is fiscally transparent because:
- all its items of income and loss are attributed to its partners; and
- it doesn’t recognize income itself.
The U.S. corporate shareholder will not treat any of the Country Z entity’s income as its own on its U.S. income tax return. And the Country Z entity also will not recognize income on it’s local income tax return.
Because neither related entity will have income after a payment is paid between those entities, a “dual no-inclusion income” or D/NI situation would result. And IRC §267A would kick in.
Payments to Reverse Hybrids
A payment made to a reverse hybrid that cannot be deducted is called a “disqualified hybrid amount.”
As described, IRC §267A doesn’t allow a deduction for any “disqualified related party amount” paid or accrued:
- in a hybrid transaction; or
- by, or to, a hybrid entity.
For reverse hybrids, a payment is a “disqualified hybrid amount” to the extent that two circumstances exist:
- First, an investor treats the reverse hybrid as a legal entity and does not include the payment in income.
- Second, if the reverse hybrid were disregarded by the investor, the investor would treat the payment as income.
Example of a Payment to a Reverse Hybrid
Foreign Company X (FCX) is a corporation established in Country X. FCX holds all the interests of US1 and all the interests of FY.
US is an entity organized in the United States. FY is organized in Country Y.
The Reverse Hybrid
FY is fiscally transparent under Country Y law. But it is not fiscally transparent under Country X tax law. It is a reverse hybrid under IRC §267A.
On date 1, US1 pays $100x to FY. The payment is treated as interest for U.S. tax purposes and Country X tax purposes. US1 would deduct the interest payment.
However, US1 made the payment to a reverse hybrid.
Under Country Y law, the interest income passes through to FCX. FY would not report the interest income.
Under Country X law, FY is treated as having received the income from the interest payment.
FCX also would not report interest income from the payment made by US1.
The Tax Outcome
FCX has no income inclusion from the interest payment because the US1 made the payment to a reverse hybrid. If Country X treated FY as fiscally transparent, then FCX would include the $100 interest payment in income.
If US1 deducted the interest payment and neither FCX or FY recognized income from the payment, the result would be a “dual no-inclusion income” or D/NI situation
Because a no-income inclusion occurs in the transaction, US1’s payment is a “disqualified hybrid amount”. This means that, under IRC §267A, US1 is not allowed to deduct the interest payment.
Payments Made Indirectly to a Reverse Hybrid
Under Reg. §1.267A-2(d)(3), a payment made to an entity directly (or indirectly) owned by a reverse hybrid can be treated as made to the reverse hybrid itself.
This rule applies when the tax law of the owner treats the entity owned by the hybrid as fiscally transparent.
In fact, this rule applies if all intermediate entities between the reverse hybrid and the owning entity are fiscally transparent.
Second Example Involving Another Related Party
FY from our earlier example holds all the interests of FV. FV is an entity established in Country V. US1 makes a $100 interest payment to FV.
FV is fiscally transparent under Country X tax law.
Under Country X tax law, the $100 interest payment is received by FY. However, FY will not recognize the $100 income under local tax law. The result is a no-income inclusion for the $100 interest payment.
Again, IRC §267A will apply, and US1 would not be allowed to deduct the interest payment.
No Deductions for Payments to IRC §267A Reverse Hybrids
Taxpayers have, in the past, created elaborate corporate structures involving reverse hybrids to get tax deductions for payments that no related party will recognize as income.
This has been an effective tax avoidance strategy for years.
Treasury regulations include more examples of royalties and interest payments made to reverse hybrids that will result in a taxpayer not being allowed to take a deduction.
By Lisa Lopata, J.D.