Treatment of hybrid arrangements under Subpart F.
The recent "check-the-box" regulations, Regs. Secs. 301.7701-1-3, have facilitated the creation of the hybrid branches used in these arrangements. In the preamble to these regulations, the Treasury and the Service said it would be monitoring the use of partnerships in the international context, since there was a concern that fiscally transparent entities could be used in a manner inconsistent with the policies and rules of particular Code provisions.
The Treasury and the IRS have concluded that the use of certain hybrid-branch arrangements, such as the ones illustrated below, is contrary to Subpart F's policies and rules. Notice 98-11 announced that the Treasury and the Service will issue regulations to address such arrangements and requested public comments on these Subpart F issues. The notice does not specify a deadline for these comments.
Subpart F limits deferral of U.S. tax on certain income earned outside the U.S. by CFCs. Limited deferral was retained after Subpart F's enactment to protect the competitiveness of CFCs doing business overseas. This limited deferral allows 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.
However, under Subpart F, transactions of CFCs that involve related persons frequently give rise to Subpart F income, unless an exception applies. Related-person transactions can be more easily manipulated to reduce both U.S. and foreign taxes. One of Subpart F's purposes is to prevent CFCs (including those engaged in active businesses) from structuring transactions designed to manipulate the inconsistencies between foreign tax systems to inappropriately generate low- or nontaxed income on which U.S. tax might be permanently deferred.
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) with the need to keep U.S. business competitive. Subpart F strongly reflects and enforces that balance. The IRS believes that these hybrid transactions upset that balance.
Arrangements Involving Hybrid Branches
A hybrid branch is one that is viewed under U.S. tax principles to be part of the CFC (i.e., fiscally transparent), but under the law of the CFC's country of incorporation, as an entity separate from the CFC (i.e., nonfiscally transparent). The types of hybrid branch arrangements the Treasury and the Service have identified as being inconsistent with Subpart F's policies and rules may be illustrated by the following examples:
Example 1: CFC1 owns all of the stock of CFC2. CFC1 and CFC2 are both incorporated in Country A. CFC1 also has a branch (BR1) in Country B. The tax laws of A and B classify CFC1, CFC2 and BR1 as separate, nonfiscally transparent entities. CFC2 earns only non-Subpart F income and uses a substantial part of its assets in a trade or business in A. BR1 makes a transfer to CFC2 that the tax laws of both A and B recognize as a loan from BR1 to CFC2. CFC2 pays interest to BR1. A allows CFC2 to deduct the interest from taxable income. Little or no tax is paid by BR1 to B on the receipt of interest.
If BR1 is disregarded, for U.S. tax purposes, the loan would be regarded as being made by CFC1 to CFC2 and the interest as being paid by CFC2 to CFC1. While interest received by a CFC is normally Subpart F income under Sec. 954(c) (foreign personal holding company income), in this case, if BR1 is disregarded, the "same country" exception of Sec. 954(c)(3) would apply to exclude the interest from Subpart F income.
However, if BR1 instead were considered to be a CFC, this payment would be between two CFCs located in different countries. In that case, Subpart F income would arise because the same-country exception would not apply. Thus, if BR1 is disregarded, CFC1 will have lowered its foreign tax on deferred income and created a significant tax incentive to invest abroad rather than in the U.S. As this arrangement creates income intended to be Subpart F income, but not subject to Subpart F in this case, the arrangement's result is inconsistent with Subpart F's policies and rules.
Example 2: CFC3 is incorporated in Country A. CFC3 has a branch (BR2) in Country B. The tax laws of A and B classify CFC3 and BR2 as separate, nonfiscally transparent entities. BR2 makes a transfer to CFC3 that the tax laws of both A and B recognize as a loan from BR2 to CFC3. CFC3, which earns only non-Subpart F income, pays interest to BR2 that A allows as a deduction against taxable income. Little or no tax is paid by BR2 on the receipt of interest.
If BR2 is disregarded, U.S. tax law would not recognize the income flows (neither the loan nor the interest payment) between the CFC and its branch. Therefore, Subpart F would not apply.
However, if this transaction were between two CFCs, the interest would be Subpart F income under Sec. 954(c) and no exception would apply. Thus, if BR2 is disregarded, by use of this arrangement, the CFC will have lowered its foreign tax on deferred income in a manner inconsistent with Subpart F's policies and rules.
The Treasury and the IRS believe that it is appropriate to prevent taxpayers from using these types of hybrid-branch arrangements to reduce foreign tax while avoiding the corresponding creation of Subpart F income. To that end, temporary and proposed regulations have been issued on the hybrid branches, effective March 23, 1998.
Partnerships and Trusts
The Treasury and the Service are aware that the issues under Subpart F raised by hybrid-branch arrangements also may be raised by certain Partnership or trust arrangements. They intend to address these issues in separate, ongoing regulations.
The regulations on hybrid-branch arrangements will apply to all such arrangements entered into (or substantially modified, including, for example, by acceleration of payments or increases in principal) after Jan. 15, 1998. In addition, for all hybrid-branch arrangements entered into before Jan. 16, 1998, these regulations will apply to all payments (or other transfers) made or accrued after June 30, 1998.
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|Title Annotation:||IRC Subpart|
|Author:||Josephs, Stuart R.|
|Publication:||The Tax Adviser|
|Date:||May 1, 1998|
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