Regulations issued for Notice 98-11.

On Jan. 16, 1998, the IRS issued Notice 98-11, announcing that regulations would be issued to treat a controlled foreign corporation (CFC) and its "hybrid branch" as separate corporations for purposes of subpart F, in the case of certain, arrangements designed "to circumvent the purposes of Subpart F, (Notice 98-11 was discussed in the May 1098 Tax Clinic article, "Treatment of Hybrid Arrangements Under Subpart F.") On March 23,1998, the Service, delivered on this promise by issuing temporary and final subpart F regulations (TD 8767) on hybrid entity arrangements.

The new regulations address two examples cited in Notice 98-11 as purportedly abusive hybrid entity arrangements. In Example 1, a CFC sought the "same-country" exception on its payment of interest to a hybrid branch of a related same-country CFC. In Example 2, a CFC pays interest to its own hybrid branch. In both examples, the CFC paying the interest reduces its foreign tax and seeks to avoid generating a corresponding amount of subpart F income for inclusion in the U.S. shareholder's gross income. Temp. Regs. Sec. 1.954-9T approaches this area by first creating a generally uniform set of concepts that must be present before the new rules will apply:

* Inconsistent tax treatment of entities: There must be some inconsistency in the fiscal transparency, or lack thereof, between U.S. and foreign law, of an entity. Temp. Regs. Sec. 1.954-9T(a)(7) provides a definition of fiscal transparency more detailed than that provided by Notice 98-11.

* Foreign income tax reduction: The payment must either reduce the foreign income tax of the payor or an owner of the payor, or generate a tax attribute that may be carried over to reduce the foreign income tax of the payor or owner in another year (Temp. Regs. Sec. 1.954-9T(a)(1) and (3)).

* Disparity between foreign effective tax rates: There must be a sufficient disparity in the income tax rates of the payor and the payee of the payment. To constitute a sufficient disparity, the payment must be taxed in the year when earned at an effective rate of tax that is less than 90% of, and at least five percentage points less than, the "hypothetical" effective tax rate imposed on the payment. The hypothetical effective rate depends on the tax rates that would have applied to the payor (Temp. Regs. Sec. 1.954-9T(a)(5)(iv)).

The regulations create three new rules, each of which is triggered by meeting these inconsistency, tax disparity and foreign tax reduction tests. Each of these three new rules applies to a different fact pattern and yields different consequences:

* Shadow subpart F regime: For certain nonincome-producing events (situations like Example 2 in Notice 98-11), Temp. Regs. Sec. 1.954-9T(a) creates a "shadow" subpart F regime. This regime creates a new category of"subpart F income" comprised of non-subpart F income "recharacterized" as subpart F income subject to a new high-tax exception, and a new earnings and profits (E&P) limitation. The nonincome-producing events that result in recharacterization are "hybrid branch payments"--payments between a CFC (or a partnership of which a CFC is a partner) and its own branch, or two branches of the same CFC (or partnership).

* Denial of same-country exception: For certain payments previously exempt from subpart F income inclusion under the Code's "same-country exceptions" to foreign personal holding company income (FPHCD, the regulations void the application of the same-country exceptions. The cases affected are those similar to Example 1 in Notice 98-11, in which (1) a CFC pays interest, rents or royalties to a hybrid branch of another CFC (or to a partnership in which another CFC is a partner) or (2) a CFC receives interest, rents or royalties from a hybrid branch of another CFC.

* Partnership expense allocation rule: For situations involving payments between a CFC and a partnership in which a CFC is a partner, the regulations modify existing expense allocation regulations. These modifications generally prevent taxpayers from sheltering the subpart F income generated by CFC partner-partnership payments by using the deductions generated by those same payments. This type of case was not addressed in Notice 98-11.

Shadow Subpart F Regime for Hybrid Branch Payments

The new "shadow subpart F regime" creates a new class of subpart F income--non-subpart F income re-characterized as subpart F income. There is no limit on the types of non-subpart F income that can be so recharacterized (e.g., manufacturing income may be so recharacterized). However, the amount of non-subpart F income that can be recharacterized is limited to the amount of hybrid branch payments "treated as falling within a category of FPHCI." To determine whether hybrid branch payments fall within such a category, the hybrid branch is treated as a separate corporation wholly owned by the CFC, incorporated in the jurisdiction under the laws of Which the branch is created, organized or in which the branch has substantial assets. If a partnership is the owner of a hybrid branch, application of the FPHCI rules is modified, depending on whether the Partnership is fiscally transparent for foreign tax law purposes.

A second limit on the amount of recharacterized non-subpart F income is the excess of the E&P of the CFC over actual subpart F income A special high-tax exception eliminates recharacterization altogether if foreign effective tax rates on the income to be recharacterized are more than 90% of the maximum rate of U.S. corporate tax.

Denial of Same-Country Exception to Avoid Subpart F Income

The modification to the same-country exception addresses situations in which, for U.S. tax purposes, there is a payment from a CFC to a second CFC (or a partnership of which the latter is a partner), incorporated in the same country as the first CFC; for foreign tax law purposes, a nonfiscally transparent entity is interposed between the two. The taxpayer's goal is both to reduce the foreign tax on the first CFC and to have the second CFC avoid FPHCI treatment via a "same-country exception." The new regulations place additional restrictions, for certain hybrid arrangements, on the availability of these same-country exceptions. The new limitation on same-country benefits applies to payments received or paid by a hybrid branch. The limitation also applies to payments received (but not paid) by a partnership.

* Hybrid branches: For payments between a CFC (or its hybrid branch) and the hybrid branch of a related CFC, the new regulations limit the same-country exception to situations in which it would have applied had both the payor and payee been separate CFCs, the payor was created or organized in the jurisdiction where foreign tax is reduced, and the payee was created or organized under the laws of the jurisdiction in which the payment is subject to tax other than a withholding tax. This new Imitation on the use of the same-country exception is not triggered, however, unless the "foreign tax reduction" and "tax disparity" factors are also present.

* Partnerships: For a CFC's distributive share of an item of income received by a partnership in which a CFC is a partner (in which the item reduced the payor's foreign income), two additional prerequisites to achieving same-country benefits must be met. These prerequisites are based on the IRS's general position on the subpart F treatment of a CFC partner's distributive share of income from a partnership:

1. The same-country exception would have applied to exclude the income from FPHCI if the CFC had earned the income directly.

2. The partnership's income was not received from the CFC partner.

If both of these requirements are met, the CFCs distributive share of the partnership's interest, rent or royalty income may qualify for the same-country exception, but only if one of three additional criteria are met. Interest, rent or royalty income can be excluded from subpart F under the same-country exceptions if, but only if (1) there is no tax disparity, (2) the partnership is treated as fiscally transparent by all relevant foreign countries or (3) the partnership is created or organized in (and uses a substantial part of its assets in a trade or business in) its CFC partner's country of incorporation.

Expense Allocation to Partnership Income Distributive Shares

The remaining aspect of the new regulations applies if a CFC simultaneously generates an expense and gross "foreign base company income" (a component of subpart F income) by making a payment to, or receiving a payment from, a partnership of which the CFC is a partner. This situation was not addressed in Notice 98-11; prior to the new regulations, it would have represented a way to obtain tax benefits similar to those sought by having a CFC pay interest to its hybrid branch. For example, a CFCs distributive share of its partnership's interest income has the potential to generate a subpart F inclusion to the CFCs U.S. shareholder. To determine the amount of the inclusion, however, the CFCs distributive share must be reduced by the CFC's allocable expenses. Under prior regulations, a CFC's interest expense deduction arising from the payment to the partnership may have been allocable against its distributive share of the partnership's interest income, resulting in no net subpart F income for inclusion by the U.S. shareholder. The new regulations, however, generally preclude the allocation of the interest deduction arising from the CFC's payment to die partnership against its distributive share of partnership income arising from that payment.

Effective Dates

The effective dates of the new regulations represent a major retreat for the Service. Notice 98-11 stated that the regulations on hybrid branch arrangements would be effective retroactive to Jan. 16, 1998. The regulations, however, appear to give all such pre-January 16 arrangements permanent "grandfather" status, barring "substantial modification." Further, arrangements involving partnerships in place prior to March 23, 1998 are also grandfathered. If, however, a grandfathered arrangement is "substantially" modified, its protected status is revoked. A "substantial modification" is any "measure which materially increases the tax benefit of the arrangement," including an "expansion of the arrangement ... such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement" or "changes in direct or indirect control of any entity that is a party to the arrangement." The determination of what constitutes a substantial modification will be crucial for taxpayers seeking protection for pre-existing arrangements and the grandfathered provisions. Given this broad and ambiguous definition, taxpayers should use extreme caution when modifying any aspect of a hybrid branch or partnership arrangement grandfathered under these regulations.