Rules Regarding Certain Hybrid Arrangements, 67612-67651 [2018-27714]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 83, Number 248 (Friday, December 28, 2018)]
[Proposed Rules]
[Pages 67612-67651]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-27714]



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Vol. 83

Friday,

No. 248

December 28, 2018

Part III





Department of the Treasury





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Internal Revenue Service





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26 CFR Parts 1 and 301





Rules Regarding Certain Hybrid Arrangements; Proposed Rule

Federal Register / Vol. 83 , No. 248 / Friday, December 28, 2018 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[REG-104352-18]
RIN 1545-BO53


Rules Regarding Certain Hybrid Arrangements

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations implementing 
sections 245A(e) and 267A of the Internal Revenue Code (``Code'') 
regarding hybrid dividends and certain amounts paid or accrued in 
hybrid transactions or with hybrid entities. Sections 245A(e) and 267A 
were added to the Code by the Tax Cuts and Jobs Act, Public Law 115-97 
(2017) (the ``Act''), which was enacted on December 22, 2017. This 
document also contains proposed regulations under sections 1503(d) and 
7701 to prevent the same deduction from being claimed under the tax 
laws of both the United States and a foreign country. Further, this 
document contains proposed regulations under sections 6038, 6038A, and 
6038C to facilitate administration of certain rules in the proposed 
regulations. The proposed regulations affect taxpayers that would 
otherwise claim a deduction related to such amounts and certain 
shareholders of foreign corporations that pay or receive hybrid 
dividends.

DATES: Written or electronic comments and requests for a public hearing 
must be received by February 26, 2019.

ADDRESSES: Send submissions to: Internal Revenue Service, CC:PA:LPD:PR 
(REG-104352-18), Room 5203, Post Office Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (indicate 
REG-104352-18), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW, Washington, DC 20224, or sent electronically, 
via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-
104352-18).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
contact Tracy Villecco at (202) 317-3800; concerning submissions of 
comments or requests for a public hearing, Regina L. Johnson at (202) 
317-6901 (not toll free numbers).

SUPPLEMENTARY INFORMATION: 

Background

I. In General

    This document contains proposed amendments to 26 CFR parts 1 and 
301 under sections 245A(e), 267A, 1503(d), 6038, 6038A, 6038C, and 7701 
(the ``proposed regulations''). Added to the Code by sections 14101(a) 
and 14222(a) of the Act, section 245A(e) denies the dividends received 
deduction under section 245A with respect to hybrid dividends, and 
section 267A denies certain interest or royalty deductions involving 
hybrid transactions or hybrid entities. The proposed regulations only 
include rules under section 245A(e); rules addressing other aspects of 
section 245A, including the general eligibility requirements for the 
dividends received deduction under section 245A(a), will be addressed 
in a separate notice of proposed rulemaking. Section 14101(f) of the 
Act provides that section 245A, including section 245A(e), applies to 
distributions made after December 31, 2017. Section 14222(c) of the Act 
provides that section 267A applies to taxable years beginning after 
December 31, 2017. Other provisions of the Code, such as sections 
894(c) and 1503(d), also address certain hybrid arrangements.

II. Purpose of Anti-Hybrid Rules

    A cross-border transaction may be treated differently for U.S. and 
foreign tax purposes because of differences in the tax law of each 
country. In general, the U.S. tax treatment of a transaction does not 
take into account foreign tax law. However, in specific cases, foreign 
tax law is taken into account--for example, in the context of 
withholdable payments to hybrid entities for which treaty benefits are 
claimed under section 894(c) and for dual consolidated losses subject 
to section 1503(d)--in order to address policy concerns resulting from 
the different treatment of the same transaction or arrangement under 
U.S. and foreign tax law.
    In response to international concerns regarding hybrid arrangements 
used to achieve double non-taxation, Action 2 of the OECD's Base 
Erosion and Profit Shifting (``BEPS'') project, and two final reports 
thereunder, address hybrid and branch mismatch arrangements. See OECD/
G20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 
2: 2015 Final Report (October 2015) (the ``Hybrid Mismatch Report''); 
OECD/G20, Neutralising the Effects of Branch Mismatch Arrangements, 
Action 2: Inclusive Framework on BEPS (July 2017) (the ``Branch 
Mismatch Report''). The Hybrid Mismatch Report sets forth 
recommendations to neutralize the tax effects of hybrid arrangements 
that exploit differences in the tax treatment of an entity or 
instrument under the laws of two or more countries (such arrangements, 
``hybrid mismatches''). The Branch Mismatch Report sets forth 
recommendations to neutralize the tax effects of certain arrangements 
involving branches that result in mismatches similar to hybrid 
mismatches (such arrangements, ``branch mismatches''). Given the 
similarity between hybrid mismatches and branch mismatches, the Branch 
Mismatch Report recommends that a jurisdiction adopting rules to 
address hybrid mismatches adopt, at the same time, rules to address 
branch mismatches. See Branch Mismatch Report, at p. 11, Executive 
Summary. Otherwise, taxpayers might ``shift[[hairsp]] from hybrid 
mismatch to branch mismatch arrangements in order to secure the same 
tax advantages.'' Id.
    The Act's legislative history explains that section 267A is 
intended to be ``consistent with many of the approaches to the same or 
similar problems [regarding hybrid arrangements] taken in the Code, the 
OECD base erosion and profit shifting project (``BEPS''), bilateral 
income tax treaties, and provisions or rules of other countries.'' See 
Senate Committee on Finance, Explanation of the Bill, at 384 (November 
22, 2017). The types of hybrid arrangements of concern are arrangements 
that ``exploit differences in the tax treatment of a transaction or 
entity under the laws of two or more tax jurisdictions to achieve 
double non-taxation, including long-term deferral.'' Id. Hybrid 
arrangements targeted by these provisions are those that rely on a 
hybrid element to produce such outcomes.
    These concerns also arise in the context of section 245A as a 
result of the enactment of a participation exemption system for taxing 
foreign income. Under this system, section 245A(e) generally prevents 
double non-taxation by disallowing the 100 percent dividends received 
deduction for dividends received from a controlled foreign corporation 
(``CFC''), or by mandating subpart F inclusions for dividends received 
from a CFC by another CFC, if there is a corresponding deduction or 
other tax benefit in the foreign country.

Explanation of Provisions

I. Section 245A(e)--Hybrid Dividends

A. Overview

    The proposed regulations under section 245A(e) address certain 
dividends involving hybrid arrangements. The proposed regulations

[[Page 67613]]

neutralize the double non-taxation effects of these dividends by either 
denying the section 245A(a) dividends received deduction with respect 
to the dividend or requiring an inclusion under section 951(a) with 
respect to the dividend, depending on whether the dividend is received 
by a domestic corporation or a CFC.
    The proposed regulations provide that if a domestic corporation 
that is a United States shareholder within the meaning of section 
951(b) (``U.S. shareholder'') of a CFC receives a ``hybrid dividend'' 
from the CFC, then the U.S. shareholder is not allowed the section 
245A(a) deduction for the hybrid dividend, and the rules of section 
245A(d) (denial of foreign tax credits and deductions) apply. See 
proposed Sec.  1.245A(e)-1(b). In general, a dividend is a hybrid 
dividend if it satisfies two conditions: (i) But for section 245A(e), 
the section 245A(a) deduction would be allowed, and (ii) the dividend 
is one for which the CFC (or a related person) is or was allowed a 
deduction or other tax benefit under a ``relevant foreign tax law'' 
(such a deduction or other tax benefit, a ``hybrid deduction''). See 
proposed Sec.  1.245A(e)-1(b) and (d). The proposed regulations take 
into account certain deductions or other tax benefits allowed to a 
person related to a CFC (such as a shareholder) because, for example, 
certain tax benefits allowed to a shareholder of a CFC are economically 
equivalent to the CFC having been allowed a deduction.

B. Relevant Foreign Tax Law

    The proposed regulations define a relevant foreign tax law as, with 
respect to a CFC, any regime of any foreign country or possession of 
the United States that imposes an income, war profits, or excess 
profits tax with respect to income of the CFC, other than a foreign 
anti-deferral regime under which an owner of the CFC is liable to tax. 
See proposed Sec.  1.245A(e)-1(f). Thus, for example, a relevant 
foreign tax law includes the tax law of a foreign country of which the 
CFC is a tax resident, as well as the tax law applicable to a foreign 
branch of the CFC.

C. Deduction or Other Tax Benefit

1. In General
    Under the proposed regulations, only deductions or other tax 
benefits that are ``allowed'' under the relevant foreign tax law may 
constitute a hybrid deduction. See proposed Sec.  1.245A(e)-1(d). Thus, 
for example, if the relevant foreign tax law contains hybrid mismatch 
rules under which a CFC is denied a deduction for an amount of interest 
paid with respect to a hybrid instrument to prevent a deduction/no-
inclusion (``D/NI'') outcome, then the payment of the interest does not 
give rise to a hybrid deduction, because the deduction is not 
``allowed.'' This prevents double-taxation that could arise if a hybrid 
dividend were subject to both section 245A(e) and a hybrid mismatch 
rule under a relevant foreign tax law.
    For a deduction or other tax benefit to be a hybrid deduction, it 
must relate to or result from an amount paid, accrued, or distributed 
with respect to an instrument of the CFC that is treated as stock for 
U.S. tax purposes. That is, there must be a connection between the 
deduction or other tax benefit under the relevant foreign tax law and 
the instrument that is stock for U.S. tax purposes. Thus, a hybrid 
deduction includes an interest deduction under a relevant foreign tax 
law with respect to a hybrid instrument (stock for U.S. tax purposes, 
indebtedness for foreign tax purposes). It also includes dividends paid 
deductions and other deductions allowed on equity under a relevant 
foreign tax law, such as notional interest deductions (``NIDs''), which 
raise similar concerns as traditional hybrid instruments. However, it 
does not, for example, include an exemption provided to a CFC under its 
tax law for certain types of income (such as income attributable to a 
foreign branch), because there is not a connection between the tax 
benefit and the instrument that is stock for U.S. tax purposes.
    The proposed regulations provide that deductions or other tax 
benefits allowed pursuant to certain integration or imputation systems 
do not constitute hybrid deductions. See proposed Sec.  1.245A(e)-
1(d)(2)(i)(B). However, a system that has the effect of exempting 
earnings that fund a distribution from foreign tax at both the CFC and 
shareholder level gives rise to a hybrid deduction. See id.; see also 
proposed Sec.  1.245A(e)-1(g)(2), Example 2.
2. Effect of Foreign Currency Gain or Loss
    The payment of an amount by a CFC may, under a provision of foreign 
tax law comparable to section 988, give rise to gain or loss to the CFC 
that is attributable to foreign currency. The proposed regulations 
provide that such foreign currency gain or loss recognized with respect 
to such deduction or other tax benefit is taken into account for 
purposes of determining hybrid deductions. See proposed Sec.  
1.245A(e)-1(d)(6); see also section II.K.1 of this Explanation of 
Provisions (requesting comments on foreign currency rules).

D. Tiered Hybrid Dividends

    Proposed Sec.  1.245A(e)-1(c) sets forth rules related to hybrid 
dividends of tiered corporations (``tiered hybrid dividends''), as 
provided under section 245A(e)(2). A tiered hybrid dividend means an 
amount received by a CFC from another CFC to the extent that the amount 
would be a hybrid dividend under proposed Sec.  1.245A(e)-1(b) if the 
receiving CFC were a domestic corporation. Accordingly, the amount must 
be treated as a dividend under U.S. tax law to be treated as a tiered 
hybrid dividend; the treatment of the amount under the tax law in which 
the receiving CFC is a tax resident (or under any other foreign tax 
law) is irrelevant for this purpose.
    If a CFC receives a tiered hybrid dividend from another CFC, and a 
domestic corporation is a U.S. shareholder of both CFCs, then (i) the 
tiered hybrid dividend is treated as subpart F income of the receiving 
CFC, (ii) the U.S. shareholder must include in gross income its pro 
rata share of the subpart F income, and (iii) the rules of section 
245A(d) apply to the amount included in the U.S. shareholder's gross 
income. See proposed Sec.  1.245A(e)-1(c)(1). This treatment applies 
notwithstanding any other provision of the Code. Thus, for example, 
exceptions to subpart F income such as those provided under section 
954(c)(3) (``same country'' exception for income received from related 
persons) and section 954(c)(6) (look-through rule for related CFCs) do 
not apply. As additional examples, the gross amount of subpart F income 
cannot be reduced by deductions taken into account under section 
954(b)(5) and Sec.  1.954-1(c), and is not subject to the current 
earnings and profits limitation under section 952(c).

E. Interaction With Section 959

    Distributions of previously taxed earnings and profits (``PTEP'') 
attributable to amounts that have been taken into account by a U.S. 
shareholder under section 951(a) are, in general, excluded from the 
gross income of the U.S. shareholder when distributed under section 
959(a), and under section 959(d) are not treated as a dividend (other 
than to reduce earnings and profits). As a result, distributions from a 
CFC to its U.S. shareholder out of PTEP are not eligible for the 
dividends received deduction under section 245A(a), and section 245A(e) 
does not apply. Similarly, distributions of PTEP from a CFC to an 
upper-tier CFC are excluded from the gross income of the upper-tier CFC 
under section 959(b), but

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only for the limited purpose of applying section 951(a). In addition, 
such amounts continue to be treated as dividends because section 959(d) 
does not apply to such amounts. Accordingly, distributions out of PTEP 
could qualify as tiered hybrid dividends that would result in an income 
inclusion to a U.S. shareholder. To prevent this result, the proposed 
regulations provide that a tiered hybrid dividend does not include 
amounts described in section 959(b). See proposed Sec.  1.245A(e)-
1(c)(2).

F. Interaction With Section 964(e)

    Under section 964(e)(1), gain recognized by a CFC on the sale or 
exchange of stock in another foreign corporation may be treated as a 
dividend. In certain cases, section 964(e)(4): (i) Treats the dividend 
as subpart F income of the selling CFC; (ii) requires a U.S. 
shareholder of the CFC to include in its gross income its pro rata 
share of the subpart F income; and (iii) allows the U.S. shareholder 
the section 245A(a) deduction for its inclusion in gross income. As is 
the case with the treatment of tiered hybrid dividends, the treatment 
of dividends under section 964(e)(4) applies notwithstanding any other 
provision of the Code.
    The proposed regulations coordinate the tiered hybrid dividend 
rules and the rules of section 964(e) by providing that, to the extent 
a dividend arising under section 964(e)(1) is a tiered hybrid dividend, 
the tiered hybrid dividend rules, rather than the rules of section 
964(e)(4), apply. Thus, in such a case, a U.S. shareholder that 
includes an amount in its gross income under the tiered hybrid dividend 
rule is not allowed the section 245A(a) deduction, or foreign tax 
credits or deductions, for the amount. See proposed Sec.  1.245A(e)-
1(c)(1) and (4).

G. Hybrid Deduction Accounts

1. In General
    In some cases, the actual payment by a CFC of an amount that is 
treated as a dividend for U.S. tax purposes will result in a 
corresponding hybrid deduction. In many cases, however, the dividend 
and the hybrid deduction may not arise pursuant to the same payment and 
may be recognized in different taxable years. This may occur in the 
case of a hybrid instrument for which under a relevant foreign tax law 
the CFC is allowed deductions for accrued (but not yet paid) interest. 
In such a case, to the extent that an actual payment has not yet been 
made on the instrument, there generally would not be a dividend for 
U.S. tax purposes for which the section 245A(a) deduction could be 
disallowed under section 245A(e). Nevertheless, because the earnings 
and profits of the CFC would not be reduced by the accrued interest 
deduction, the earnings and profits may give rise to a dividend when 
subsequently distributed to the U.S. shareholder. This same result 
could occur in other cases, such as when a relevant foreign tax law 
allows deductions on equity, such as NIDs.
    The disallowance of the section 245A(a) deduction under section 
245A(e) should not be limited to cases in which the dividend and the 
hybrid deduction arise pursuant to the same payment (or in the same 
taxable year for U.S. tax purposes and for purposes of the relevant 
foreign tax law). Interpreting the provision in such a manner would 
result in disparate treatment for hybrid arrangements that produce the 
same D/NI outcome. Accordingly, the proposed regulations define a 
hybrid dividend (or tiered hybrid dividend) based, in part, on the 
extent of the balance of the ``hybrid deduction accounts'' of the 
domestic corporation (or CFC) receiving the dividend. See proposed 
Sec.  1.245A(e)-1(b) and (d). This ensures that dividends are subject 
to section 245A(e) regardless of whether the same payment gives rise to 
the dividend and the hybrid deduction.
    A hybrid deduction account must be maintained with respect to each 
share of stock of a CFC held by a person that, given its ownership of 
the CFC and the share, could be subject to section 245A upon a dividend 
paid by the CFC on the share. See proposed Sec.  1.245A(e)-1(d) and 
(f). The account, which is maintained in the functional currency of the 
CFC, reflects the amount of hybrid deductions of the CFC (allowed in 
taxable years beginning after December 31, 2017) that have been 
allocated to the share. A dividend paid by a CFC to a shareholder that 
has a hybrid deduction account with respect to the CFC is generally 
treated as a hybrid dividend or tiered hybrid dividend to the extent of 
the shareholder's balance in all of its hybrid deduction accounts with 
respect to the CFC, even if the dividend is paid on a share that has 
not had any hybrid deductions allocated to it. Absent such an approach, 
the purposes of section 245A(e) might be avoided by, for example, 
structuring dividend payments such that they are generally made on 
shares of stock to which a hybrid deduction has not been allocated 
(rather than on shares of stock to which a hybrid deduction has been 
allocated, such as a share that is a hybrid instrument).
    Once an amount in a hybrid deduction account gives rise to a hybrid 
dividend or a tiered hybrid dividend, the account is correspondingly 
reduced. See proposed Sec.  1.245A(e)-1(d). The Treasury Department and 
the IRS request comments on whether hybrid deductions attributable to 
amounts included in income under section 951(a) or section 951A should 
not increase the hybrid deduction account, or, alternatively, the 
hybrid deduction account should be reduced by distributions of PTEP, 
and on whether the effect of any deemed paid foreign tax credits 
associated with such inclusions or distributions should be considered.
2. Transfers of Stock
    Because hybrid deduction accounts are with respect to stock of a 
CFC, the proposed regulations include rules that take into account 
transfers of the stock. See proposed Sec.  1.245A(e)-1(d)(4)(ii)(A). 
These rules, which are similar to the ``successor'' PTEP rules under 
section 959 (see Sec.  1.959-1(d)), ensure that section 245A(e) 
properly applies to dividends that give rise to a D/NI outcome in cases 
where the shareholder that receives the dividend is not the same 
shareholder that held the stock when the hybrid deduction was incurred. 
These rules only apply when the stock is transferred among persons that 
are required to keep hybrid deduction accounts. Thus, if the stock is 
transferred to a person that is not required to keep a hybrid deduction 
account--such as an individual or a foreign corporation that is not a 
CFC--the account terminates (subject to the anti-avoidance rule, 
discussed in section I.H of this Explanation of Provisions). Finally, 
the proposed regulations include rules that take into account certain 
non-recognition exchanges of the stock, such as exchanges in connection 
with asset reorganizations, recapitalizations, and liquidations, as 
well as transfers and exchanges that occur mid-way through a CFC's 
taxable year. See proposed Sec.  1.245A(e)-1(d)(4)(ii)(B) and (d)(5). 
The Treasury Department and the IRS request comments on these rules.
3. Dividends From Lower-Tier CFCs
    The proposed regulations provide a special rule to address earnings 
and profits of a lower-tier CFC that are included in a domestic 
corporation's income as a dividend by virtue of section 1248(c)(2). In 
these cases, the proposed regulations treat the domestic corporation as 
having certain hybrid deduction accounts with respect to the lower-tier 
CFC that are held and

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maintained by other CFCs. See proposed Sec.  1.245A(e)-1(b)(3). This 
ensures that, to the extent the earnings and profits of the lower-tier 
CFC give rise to the dividend, hybrid deduction accounts with respect 
to the lower-tier CFC are taken into account for purposes of the 
determinations under section 245A(e), even though the accounts are held 
indirectly by the domestic corporation. A similar rule applies with 
respect to gains on stock sales treated as dividends under section 
964(e)(1). See proposed Sec.  1.245A(e)-1(c)(3).

H. Anti-Avoidance Rule

    The proposed regulations include an anti-avoidance rule. This rule 
provides that appropriate adjustments are made, including adjustments 
that would disregard a transaction or arrangement, if a transaction or 
arrangement is engaged in with a principal purpose of avoiding the 
purposes of proposed Sec.  1.245A(e)-1.

II. Section 267A--Related Party Amounts Involving Hybrid Transactions 
and Hybrid Entities

A. Overview

    As indicated in the Senate Finance Committee's Explanation of the 
Bill, hybrid arrangements may exploit differences under U.S. and 
foreign tax law between the tax characterization of an entity as 
transparent or opaque or differences in the treatment of financial 
instruments or other transactions. The proposed regulations under 
section 267A address certain payments or accruals of interest or 
royalties for U.S. tax purposes (the amount of such interest or 
royalty, a ``specified payment'') that involve hybrid arrangements, or 
similar arrangements involving branches, that produce D/NI (deduction/
no inclusion) outcomes or indirect D/NI outcomes. See also section 
II.J.1 of this Explanation of Provisions (discussing certain amounts 
that are treated as specified payments). The proposed regulations 
neutralize the double non-taxation effects of the arrangements by 
denying a deduction for the specified payment to the extent of the D/NI 
outcome.

B. Scope

1. Disallowed Deductions
    The proposed regulations generally disallow a deduction for a 
specified payment if and only if the payment is (i) a ``disqualified 
hybrid amount,'' meaning that it produces a D/NI outcome as a result of 
a hybrid or branch arrangement; (ii) a ``disqualified imported mismatch 
amount,'' meaning that it produces an indirect D/NI outcome as a result 
of the effects of an offshore hybrid or branch arrangement being 
imported into the U.S. tax system; or (iii) made pursuant to a 
transaction a principal purpose of which is to avoid the purposes of 
the regulations under section 267A and it produces a D/NI outcome. See 
proposed Sec.  1.267A-1(b). Thus, the proposed regulations do not 
address D/NI outcomes that are not the result of hybridity. See also 
section II.E of this Explanation of Provisions (discussing the link 
between hybridity and a D/NI outcome). In addition, the proposed 
regulations do not address double-deduction outcomes. Section 267A is 
intended to address D/NI outcomes; transactions that produce double-
deduction outcomes are addressed through other provisions (or 
doctrines), such as the dual consolidated loss rules under section 
1503(d). See also section IV.A.1 of this Explanation of Provisions 
(discussing the dual consolidated loss rules).
2. Parties Subject to Section 267A
    The application of section 267A by its terms is not limited to any 
particular category of persons. The proposed regulations, however, 
narrow the scope of section 267A so that it applies only to deductions 
of ``specified parties.'' Deductions of persons other than specified 
parties are not subject to disallowance under section 267A because the 
deductions of such other persons generally do not have significant U.S. 
tax consequences.
    A specified party means any of (i) a tax resident of the United 
States, (ii) a CFC for which there is one or more United States 
shareholders that own (within the meaning of section 958(a)) at least 
ten percent of the stock of the CFC, and (iii) a U.S. taxable branch 
(which includes a U.S. permanent establishment of a tax treaty 
resident). See proposed Sec.  1.267A-5(a). The term generally includes 
a CFC because, for example, a specified payment made by a CFC to the 
foreign parent of the CFC's U.S. shareholder, or a specified payment by 
the CFC to an unrelated party pursuant to a structured arrangement, may 
indirectly reduce income subject to U.S. tax. Specified payments made 
by a CFC to other related CFCs or to U.S. shareholders of the CFC, 
however, typically will not be subject to section 267A because of the 
rules in proposed Sec.  1.267A-3(b) that exempt certain payments 
included in income of a U.S. tax resident or taken into account under 
the subpart F or global intangible low-tax income (``GILTI'') rules. 
See also section II.F of this Explanation of Provisions (discussing the 
relatedness or structured arrangement limitation); section II.H of this 
Explanation of Provisions (discussing exceptions for amounts included 
or includible in income). Similarly, the term includes a U.S. taxable 
branch because a payment made by the home office may be allocable to 
and thus reduce income subject to U.S. tax under sections 871(b) or 
882. See also section II.K.2 of this Explanation of Provisions 
(discussing amounts considered paid or accrued by a U.S. taxable branch 
for section 267A purposes).
    The term specified party does not include a partnership because a 
partnership generally is not liable to tax and therefore is not the 
person allowed a deduction. However, a partner of a partnership may be 
a specified party. For example, in the case of a payment made by a 
partnership a partner of which is a domestic corporation, the domestic 
corporation is a specified party and its allocable share of the 
deduction for the payment is subject to disallowance under section 
267A.

C. Amount of a D/NI Outcome

1. In General
    Proposed Sec.  1.267A-3(a) provides rules for determining the ``no-
inclusion'' aspect of a D/NI outcome--that is, the amount of a 
specified payment that is or is not included in income under foreign 
tax law. The proposed regulations provide that only ``tax residents'' 
or ``taxable branches'' are considered to include an amount in income. 
Parties other than tax residents or taxable branches, for example, an 
entity that is fiscally transparent for purposes of the relevant tax 
laws, do not include an amount in income because such parties are not 
liable to tax.
    In general, a tax resident or taxable branch includes a specified 
payment in income for this purpose to the extent that, under its tax 
law, it includes the payment in its income or tax base at the full 
marginal rate imposed on ordinary income, and the payment is not 
reduced or offset by certain items (such as an exemption or credit) 
particular to that type of payment. See proposed Sec.  1.267A-3(a)(1).
    Whether a tax resident or taxable branch includes a specified 
payment in income is determined without regard to any defensive or 
secondary rule in hybrid mismatch rules (which generally requires the 
payee to include certain amounts in income, if the payer is not denied 
a deduction for the amount), if any, under the tax resident's or 
taxable branch's tax law. Otherwise, in cases in which such tax law 
contains a secondary response, the analysis of whether the specified 
payment is

[[Page 67616]]

included in income could become circular: For example, whether the 
United States denies a deduction under section 267A may depend on 
whether the payee includes the specified payment in income, and whether 
the payee includes it in income (under a secondary response) may depend 
on whether the United States denies the deduction.
    A specified payment may be considered included in income even 
though offset by a generally applicable deduction or other tax 
attribute, such as a deduction for depreciation or a net operating 
loss. For this purpose, a deduction may be treated as being generally 
applicable even if closely related to the specified payment (for 
example, if the deduction and payment are in connection with a back-to-
back financing arrangement).
    If a specified payment is taxed at a preferential rate, or if there 
is a partial reduction or offset particular to the type of payment, a 
portion of the payment is considered included in income. The portion 
included in income is the amount that, taking into account the 
preferential rate or reduction or offset, is subject to tax at the full 
marginal rate applicable to ordinary income. See proposed Sec.  1.267A-
3(a)(1); see also proposed Sec.  1.267A-6(c), Example 2 and Example 7.
2. Timing Differences
    Some specified payments may never be included in income. For 
example, a specified payment treated as a dividend under a tax 
resident's tax laws may be permanently excluded from its income under a 
participation exemption. Permanent exclusions are always treated as 
giving rise to a no-inclusion. See proposed Sec.  1.267A-3(a)(1).
    Other specified payments, however, may be included in income but on 
a deferred basis. Some of these timing differences result from 
different methods of accounting between U.S. tax law and foreign tax 
law. For example, and subject to certain limitations such as those 
under sections 163(e)(3) and 267(a) (generally applicable to payments 
involving related parties, but not to payments involving structured 
arrangements), a specified payment may be deductible for U.S. tax 
purposes when accrued and later included in a foreign tax resident's 
income when actually paid. See also section II.K.3 of this Explanation 
of Provisions (discussing the coordination of section 267A with rules 
such as sections 163(e)(3) and 267(a)). Timing differences may also 
occur in cases in which all or a portion of a specified payment that is 
treated as interest for U.S. tax purposes is treated as a return of 
principal for purposes of the foreign tax law.
    In some cases, timing differences reverse after a short period of 
time and therefore do not provide a meaningful deferral benefit. The 
Treasury Department and the IRS have determined that routine, short-
term deferral does not give rise to the policy concerns that section 
267A is intended to address. In addition, subjecting such short-term 
deferral to section 267A could give rise to administrability issues for 
both taxpayers and the IRS, because it may be challenging to determine 
whether the taxable period in which a specified payment is included in 
income matches the taxable period in which the payment is deductible.
    Other timing differences, though, may provide a significant and 
long-term deferral benefit. Moreover, taxpayers may structure 
transactions that exploit these differences to achieve long-term 
deferral benefits. Timing differences that result in long-term deferral 
have an economic effect similar to a permanent exclusion and therefore 
give rise to policy concerns that section 267A is intended to address. 
See Senate Explanation, at 384 (expressing concern with hybrid 
arrangements that ``achieve double non-taxation, including long-term 
deferral.''). Accordingly, proposed Sec.  1.267A-3(a)(1) provides that 
short-term deferral, meaning inclusion during a taxable year that ends 
no more than 36 months after the end of the specified party's taxable 
year, does not give rise to a D/NI outcome; inclusions outside of the 
36-month timeframe, however, are treated as giving rise to a D/NI 
outcome.

D. Hybrid and Branch Arrangements Giving Rise to Disqualified Hybrid 
Amounts

1. Hybrid Transactions
    Proposed Sec.  1.267A-2(a) addresses hybrid financial instruments 
and similar arrangements (collectively, ``hybrid transactions'') that 
result in a D/NI outcome. For example, in the case of an instrument 
that is treated as indebtedness for purposes of the payer's tax law and 
stock for purposes of the payee's tax law, a payment on the instrument 
may constitute deductible interest expense of the payer and excludible 
dividend income of the payee (for instance, under a participation 
exemption).
    In general, the proposed regulations provide that a specified 
payment is made pursuant to a hybrid transaction if there is a mismatch 
in the character of the instrument or arrangement such that the payment 
is not treated as interest or a royalty, as applicable, under the tax 
law of a ``specified recipient.'' Examples of such a specified payment 
include a payment that is treated as interest for U.S. tax purposes 
but, for purposes of a specified recipient's tax law, is treated as a 
distribution on equity or a return of principal. When a specified 
payment is made pursuant to a hybrid transaction, it generally is a 
disqualified hybrid amount to the extent that the specified recipient 
does not include the payment in income.
    The proposed regulations broadly define specified recipient as (i) 
any tax resident that under its tax law derives the specified payment, 
and (ii) any taxable branch to which under its tax law the specified 
payment is attributable. See proposed Sec.  1.267A-5(a)(19). In other 
words, a specified recipient is any party that may be subject to tax on 
the specified payment under its tax law. There may be more than one 
specified recipient of a specified payment. For example, in the case of 
a specified payment to an entity that is fiscally transparent for 
purposes of the tax law of its tax resident owners, each of the owners 
is a specified recipient of a share of the payment. In addition, if the 
entity is a tax resident of the country in which it is established or 
managed and controlled, then the entity is also a specified recipient. 
Moreover, in the case of a specified payment attributable to a taxable 
branch, both the taxable branch and the home office are specified 
recipients.
    The proposed regulations deem a specified payment as made pursuant 
to a hybrid transaction if there is a long-term mismatch between when 
the specified party is allowed a deduction for the payment under U.S. 
tax law and when a specified recipient includes the payment in income 
under its tax law. This rule applies, for example, when a specified 
payment is made pursuant to an instrument viewed as indebtedness under 
both U.S. and foreign tax law and, due to a mismatch in tax accounting 
treatment between the U.S. and foreign tax law, results in long-term 
deferral. In these cases, this rule treats the long-term deferral as 
giving rise to a hybrid transaction; the rules in proposed Sec.  
1.267A-3(a)(1) (discussed in section II.C.2 of this Explanation of 
Provisions) treat the long-term deferral as creating a D/NI outcome.
    Lastly, proposed Sec.  1.267A-2(a)(3) provides special rules to 
address securities lending transactions, sale-repurchase transactions, 
and similar transactions. In these cases, a specified payment (that is, 
interest consistent with the substance of the transaction) might not be 
regarded under a foreign

[[Page 67617]]

tax law. As a result, there might not be a specified recipient of the 
specified payment under such foreign tax law, absent a special rule. To 
address this scenario, the proposed regulations provide that the 
determination of the identity of a specified recipient under the 
foreign tax law is made with respect to an amount connected to the 
specified payment and regarded under the foreign tax law--for example, 
a dividend consistent with the form of the transaction. The Treasury 
Department and the IRS request comments on whether similar rules should 
be extended to other specific transactions.
2. Disregarded Payments
    Proposed Sec.  1.267A-2(b) addresses disregarded payments. 
Disregarded payments generally give rise to a D/NI outcome because they 
are regarded under the payer's tax law and are therefore available to 
offset income not taxable to the payee, but are disregarded under the 
payee's tax law and therefore are not included in income.
    In general, the proposed regulations define a disregarded payment 
as a specified payment that, under a foreign tax law, is not regarded 
because, for example, it is a disregarded transaction involving a 
single taxpayer or between consolidated group members. For example, a 
disregarded payment includes a specified payment made by a domestic 
corporation to its foreign owner if, under the foreign tax law, the 
domestic corporation is a disregarded entity and therefore the payment 
is not regarded. It also includes a specified payment between related 
foreign corporations that are members of the same foreign consolidated 
group (or can otherwise share income or loss) if, under the foreign tax 
law, payments between group members are not regarded, or give rise to a 
deduction or similar offset to the payer member that is available to 
offset the corresponding income of the recipient member.
    In general, a disregarded payment is a disqualified hybrid amount 
only to the extent it exceeds dual inclusion income. For example, if a 
domestic corporation that for foreign tax purposes is a disregarded 
entity of its foreign owner makes a disregarded payment to its foreign 
owner, the payment is a disqualified hybrid amount only to the extent 
it exceeds the net of the items of gross income and deductible expense 
taken into account in determining the domestic corporation's income for 
U.S. tax purposes and the foreign owner's income for foreign tax 
purposes. This prevents the excess of the disregarded payment over dual 
inclusion income from offsetting non-dual inclusion income. Such an 
offset could otherwise occur, for example, through the U.S. 
consolidation regime, or a sale, merger, or similar transaction.
    A disregarded payment could also be viewed as being made pursuant 
to a hybrid transaction because the payment of interest or royalty 
would not be viewed as interest or royalty under the foreign tax law 
(since the payment is disregarded). The proposed regulations address 
disregarded payments separately from hybrid transactions, however, 
because disregarded payments are more likely to offset dual inclusion 
income and therefore are treated as disqualified hybrid amounts only to 
the extent they offset non-dual inclusion income.
3. Deemed Branch Payments
    Proposed Sec.  1.267A-2(c) addresses deemed branch payments. These 
payments result in a D/NI outcome when, under an income tax treaty, a 
deductible payment is deemed to be made by a permanent establishment to 
its home office and offsets income not taxable to the home office, but 
the payment is not taken into account under the home office's tax law.
    In general, the proposed regulations define a deemed branch payment 
as interest or royalty considered paid by a U.S. permanent 
establishment to its home office under an income tax treaty between the 
United States and the home office country. See proposed Sec.  1.267A-
2(c)(2). Thus, for example, a deemed branch payment includes an amount 
allowed as a deduction in computing the business profits of a U.S. 
permanent establishment with respect to the use of intellectual 
property developed by the home office. See, for example, the U.S. 
Treasury Department Technical Explanation to the income tax convention 
between the United States and Belgium, signed November 27, 2006 
(``[T]he OECD Transfer Pricing Guidelines apply, by analogy, in 
determining the profits attributable to a permanent establishment.'').
    When a specified payment is a deemed branch payment, it is a 
disqualified hybrid amount if the home office's tax law provides an 
exclusion or exemption for income attributable to the branch. In these 
cases, a deduction for the deemed branch payment would offset non-dual 
inclusion income and therefore give rise to a D/NI outcome. If the home 
office's tax law does not have an exclusion or exemption for income 
attributable to the branch, then, because U.S. permanent establishments 
cannot consolidate or otherwise share losses with U.S. taxpayers, there 
would generally not be an opportunity for a deduction for the deemed 
branch payment to offset non-dual inclusion income.
4. Reverse Hybrids
    Proposed Sec.  1.267A-2(d) addresses payments to reverse hybrids. 
In general, and as discussed below, a reverse hybrid is an entity that 
is fiscally transparent for purposes of the tax law of the country in 
which it is established but not for purposes of the tax law of its 
owner. Thus, payments to a reverse hybrid may result in a D/NI outcome 
because the reverse hybrid is not a tax resident of the country in 
which it is established, and the owner does not derive the payment 
under its tax law. Because this D/NI outcome may occur regardless of 
whether the establishment country is a foreign country or the United 
States, the proposed regulations provide that both foreign and domestic 
entities may be reverse hybrids. A domestic entity that is a reverse 
hybrid for this purpose therefore differs from a ``domestic reverse 
hybrid entity'' under Sec.  1.894-1(d)(2)(i), which is defined as ``a 
domestic entity that is treated as not fiscally transparent for U.S. 
tax purposes and as fiscally transparent under the laws of an interest 
holder's jurisdiction[.]''
    For an entity to be a reverse hybrid under the proposed 
regulations, two requirements must be satisfied. These requirements 
generally implement the definition of hybrid entity in section 
267A(d)(2), with certain modifications. First, the entity must be 
fiscally transparent under the tax law of the country in which it is 
established, whether or not it is a tax resident of another country. 
For this purpose, the determination of whether an entity is fiscally 
transparent with respect to an item of income is made using the 
principles of Sec.  1.894-1(d)(3)(ii) (but without regard to whether 
there is an income tax treaty in effect between the entity's 
jurisdiction and the United States).
    Second, the entity must not be fiscally transparent under the tax 
law of an ``investor.'' An investor means a tax resident or taxable 
branch that directly or indirectly owns an interest in the entity. For 
this purpose, the determination of whether an investor's tax law treats 
the entity as fiscally transparent with respect to an item of income is 
made under the principles of Sec.  1.894-1(d)(3)(iii) (but without 
regard to whether there is an income tax treaty in effect between the 
investor's jurisdiction and the United States). If an investor views 
the entity as not fiscally transparent, the investor generally will not 
be currently taxed under its tax law

[[Page 67618]]

on payments to the entity. Thus, the non-fiscally-transparent status of 
the entity is determined on an investor-by-investor basis, based on the 
tax law of each investor. In addition, a tax resident or a taxable 
branch may be an investor of a reverse hybrid even if the tax resident 
or taxable branch indirectly owns the reverse hybrid through one or 
more intermediary entities that, under the tax law of the tax resident 
or taxable branch, are not fiscally transparent. In such a case, 
however, the investor's no-inclusion would not be a result of the 
payment being made to the reverse hybrid and therefore would not be a 
disqualified hybrid amount. See also section II.E of this Explanation 
of Provisions (explaining that the D/NI outcome must be a result of 
hybridity); proposed Sec.  1.267A-6(c), Example 5 (analyzing whether a 
D/NI outcome with respect to an upper-tier investor is a result of the 
specified payment being made to the reverse hybrid).
    When a specified payment is made to a reverse hybrid, it is 
generally a disqualified hybrid amount to the extent that an investor 
does not include the payment in income. For this purpose, whether an 
investor includes the specified payment in income is determined without 
regard to a subsequent distribution by the reverse hybrid. Although a 
subsequent distribution may be included in the investor's income, the 
distribution may not occur for an extended period and, when it does 
occur, it may be difficult to determine whether the distribution is 
funded from an amount comprising the specified payment.
    In addition, if an investor takes a specified payment into account 
under an anti-deferral regime, then the investor is considered to 
include the payment in income to the extent provided under the general 
rules of proposed Sec.  1.267A-3(a). See proposed Sec.  1.267A-6(c), 
Example 5. Thus, for example, if the investor's inclusion under the 
anti-deferral regime is subject to tax at a preferential rate, the 
investor is considered to include only a portion of the specified 
payment in income.
5. Branch Mismatch Payments
    Proposed Sec.  1.267A-2(e) addresses branch mismatch payments. 
These payments give rise to a D/NI outcome due to differences between 
the home office's tax law and the branch's tax law regarding the 
allocation of items of income or the treatment of the branch. This 
could occur, for example, if the home office's tax law views a payment 
as attributable to the branch and exempts the branch's income, but the 
branch's tax law does not tax the payment.
    Under the proposed regulations, a specified payment is a branch 
mismatch payment when two requirements are satisfied. First, under a 
home office's tax law, the specified payment is treated as attributable 
to a branch of the home office. Second, under the tax law of the branch 
country, either (i) the home office does not have a taxable presence in 
the country, or (ii) the specified payment is treated as attributable 
to the home office and not the branch. When a specified payment is a 
branch mismatch payment, it is generally a disqualified hybrid amount 
to the extent that the home office does not include the payment in 
income.

E. Link Between Hybridity and D/NI Outcome

    Under section 267A(a), a deduction for a payment is generally 
disallowed if (i) the payment involves a hybrid arrangement, and (ii) a 
D/NI outcome occurs. In certain cases, although both of these 
conditions are satisfied, the D/NI outcome is not a result of the 
hybridity. For example, in the hybrid transaction context, the D/NI 
outcome may be a result of the specified recipient's tax law containing 
a pure territorial system (and thus exempting from taxation all foreign 
source income) or not having a corporate income tax, or a result of the 
specified recipient's status as a tax-exempt entity under its tax law.
    The proposed regulations provide that a D/NI outcome gives rise to 
a disqualified hybrid amount only to the extent that the D/NI outcome 
is a result of hybridity. See, for example, proposed Sec.  1.267A-
2(a)(1)(ii); see also Senate Explanation, at 384 (``[T]he Committee 
believes that hybrid arrangements exploit differences in the tax 
treatment of a transaction or entity under the laws of two or more 
jurisdictions to achieve double non-taxation . . .'') (emphasis added).
    To determine whether a D/NI outcome is a result of hybridity, the 
proposed regulations generally apply a test based on facts that are 
counter to the hybridity at issue. For example, in the hybrid 
transaction context, a specified recipient's no-inclusion is a result 
of the specified payment being made pursuant to the hybrid transaction 
to the extent that the no-inclusion would not occur were the payment to 
be treated as interest or a royalty for purposes of the specified 
recipient's tax law.
    This test also addresses cases in which, for example, a specified 
payment is made to a fiscally transparent entity (such as a 
partnership) and owners of the entity that are specified recipients of 
the payment each derive only a portion of the payment under its tax 
law. The test ensures that, with respect to each specified recipient, 
only the no-inclusion that occurs for the portion of the specified 
payment that it derives may give rise to a disqualified hybrid amount. 
In addition, as a result of the relatedness or structured arrangement 
limitation discussed in section II.F of this Explanation of Provisions, 
the no-inclusion with respect to the specified recipient is taken into 
account under the proposed regulations only if the specified recipient 
is related to the specified party or is a party to a structured 
arrangement pursuant to which the specified payment is made.

F. Relatedness or Structured Arrangement Limitation

    In determining whether a specified payment is made pursuant to a 
hybrid or branch mismatch arrangement, the proposed regulations 
generally only consider the tax laws of tax residents or taxable 
branches that are related to the specified party. See proposed Sec.  
1.267A-2(f). For example, in general, only the tax law of a specified 
recipient that is related to the specified party is taken into account 
for purposes of determining whether the specified payment is made 
pursuant to a hybrid transaction. Because a deemed branch payment by 
its terms involves a related home office, the relatedness limitation in 
proposed Sec.  1.267A-2(f) does not apply to proposed Sec.  1.267A-
2(c).
    The proposed regulations provide that related status is determined 
under the rules of section 954(d)(3) (involving ownership of more than 
50 percent of interests) but without regard to downward attribution. 
See proposed Sec.  1.267A-5(a)(14). In addition, to ensure that a tax 
resident may be considered related to a specified party even though the 
tax resident is a disregarded entity for U.S. tax purposes, the 
proposed regulations provide that such a tax resident is treated as a 
corporation for purposes of the relatedness test. A similar rule 
applies with respect to a taxable branch.
    However, the Treasury Department and the IRS are aware that some 
hybrid arrangements involving unrelated parties are designed to give 
rise to a D/NI outcome and therefore present the policy concerns 
underlying section 267A. Furthermore, it is likely that in such cases 
the specified party will have, or can reasonably obtain, the 
information necessary to comply with section 267A. Accordingly, the 
proposed regulations generally provide

[[Page 67619]]

that the tax law of an unrelated tax resident or taxable branch is 
taken into account for purposes of section 267A if the tax resident or 
taxable branch is a party to a structured arrangement. See proposed 
Sec.  1.267A-2(f). The proposed regulations set forth a test for when a 
transaction is a structured arrangement. See proposed Sec.  1.267A-
5(a)(20). In addition, the proposed regulations impute an entity's 
participation in a structured arrangement to its investors. See id. 
Thus, for example, in the case of a specified payment to a partnership 
that is a party to a structured arrangement pursuant to which the 
payment is made, a tax resident that is a partner of the partnership is 
also a party to the structured arrangement, even though the tax 
resident may not have actual knowledge of the structured arrangement.

G. Effect of Inclusion in Another Jurisdiction

    The proposed regulations provide that a specified payment is a 
disqualified hybrid amount if a D/NI outcome occurs as a result of 
hybridity in any foreign jurisdiction, even if the payment is included 
in income in another foreign jurisdiction. See proposed Sec.  1.267A-
6(c), Example 1. Absent such a rule, an inclusion of a specified 
payment in income in a jurisdiction with a (generally applicable) low 
rate might discharge the application of section 267A even though a D/NI 
outcome occurs in another jurisdiction as a result of hybridity.
    For example, assume FX, a tax resident of Country X, owns US1, a 
domestic corporation, and FZ, a tax resident of Country Z that is 
fiscally transparent for Country X tax purposes. Also, assume that 
Country Z has a single, low-tax rate applicable to all income. Further, 
assume that FX holds an instrument issued by US1, a $100x payment with 
respect to which is treated as interest for U.S. tax purposes and an 
excludible dividend for Country X tax purposes. In an attempt to avoid 
US1's deduction for the $100x payment being denied under the hybrid 
transaction rule, FX contributes the instrument to FZ, and, upon US1's 
$100x payment, US1 asserts that, although a $100x no-inclusion occurs 
with respect to FX as a result of the payment being made pursuant to 
the hybrid transaction, the payment is not a disqualified hybrid amount 
because FZ fully includes the payment in income (albeit at a low-tax 
rate). The proposed regulations treat the payment as a disqualified 
hybrid amount.
    This rule only applies for inclusions under the laws of foreign 
jurisdictions. See proposed Sec.  1.267A-3(b), and section II.H of this 
Explanation of Provisions, for exceptions that apply when the payment 
is included or includible in a U.S. tax resident's or U.S. taxable 
branch's income.
    The Treasury Department and IRS request comments on whether an 
exception should apply if the specified payment is included in income 
in any foreign jurisdiction, taking into account accommodation 
transactions involving low-tax entities.

H. Exceptions for Certain Amounts Included or Includible in a U.S. Tax 
Resident's or U.S. Taxable Branch's Income

    Proposed Sec.  1.267A-3(b) provides rules that reduce disqualified 
hybrid amounts to the extent the amounts are included or includible in 
a U.S. tax resident's or U.S. taxable branch's income. In general, 
these rules ensure that a specified payment is not a disqualified 
hybrid amount to the extent included in the income of a tax resident of 
the United States or a U.S. taxable branch, or taken into account by a 
U.S. shareholder under the subpart F or GILTI rules.
    Source-based withholding tax imposed by the United States (or any 
other country) on disqualified hybrid amounts does not neutralize the 
D/NI outcome and therefore does not reduce or otherwise affect 
disqualified hybrid amounts. Withholding tax policies are unrelated to 
the policies underlying hybrid arrangements--for example, withholding 
tax can be imposed on non-hybrid payments--and, accordingly, 
withholding tax is not a substitute for a specified payment being 
included in income by a tax resident or taxable branch. See also 
section II.L of this Explanation of Provisions (interaction with 
withholding taxes and income tax treaties). Furthermore, other 
jurisdictions applying the defensive or secondary rule to a payment 
(which generally requires the payee to include the payment in income, 
if the payer is not denied a deduction for the payment under the 
primary rule) may not treat withholding taxes as satisfying the primary 
rule and may therefore require the payee to include the payment in 
income if a deduction for the payment is not disallowed (regardless of 
whether withholding tax has been imposed).
    Thus, the proposed regulations do not treat amounts subject to U.S. 
withholding taxes as reducing disqualified hybrid amounts. 
Nevertheless, the Treasury Department and the IRS request comments on 
the interaction of the proposed regulations with withholding taxes and 
whether, and the extent to which, there should be special rules under 
section 267A when withholding taxes are imposed in connection with a 
specified payment, taking into account how such a rule could be 
coordinated with the hybrid mismatch rules of other jurisdictions.

I. Disqualified Imported Mismatch Amounts

    Proposed Sec.  1.267A-4 sets forth a rule to address ``imported'' 
hybrid and branch arrangements. This rule is generally intended to 
prevent the effects of an ``offshore'' hybrid arrangement (for example, 
a hybrid arrangement between two foreign corporations completely 
outside the U.S. taxing jurisdiction) from being shifted, or 
``imported,'' into the U.S. taxing jurisdiction through the use of a 
non-hybrid arrangement.
    Accordingly, the proposed regulations disallow deductions for 
specified payments that are ``disqualified imported mismatch amounts.'' 
In general, a disqualified imported mismatch amount is a specified 
payment: (i) That is non-hybrid in nature, such as interest paid on an 
instrument that is treated as indebtedness for both U.S. and foreign 
tax purposes, and (ii) for which the income attributable to the payment 
is directly or indirectly offset by a hybrid deduction of a foreign tax 
resident or taxable branch. The rule addresses ``indirect'' offsets in 
order to take into account, for example, structures involving 
intermediaries where the foreign tax resident that receives the 
specified payment is different from the foreign tax resident that 
incurs the hybrid deduction. See proposed Sec.  1.267A-6(c), Example 8, 
Example 9, and Example 10.
    In general, a hybrid deduction for purposes of the imported 
mismatch rule is an amount for which a foreign tax resident or taxable 
branch is allowed an interest or royalty deduction under its tax law, 
to the extent the deduction would be disallowed if such tax law were to 
contain rules substantially similar to the section 267A proposed 
regulations. For this purpose, it is not relevant whether the amount is 
recognized as interest or a royalty under U.S. law, or whether the 
amount would be allowed as a deduction under U.S. law. Thus, for 
example, a deduction with respect to equity (such as a notional 
interest deduction) constitutes a hybrid deduction even though such a 
deduction would not be recognized (or allowed) under U.S. tax law. As 
another example, a royalty deduction under foreign tax law may 
constitute a hybrid deduction even though for U.S. tax purposes the 
royalty is viewed as made

[[Page 67620]]

from a disregarded entity to its owner and therefore is not regarded.
    The requirement that the deduction would be disallowed if the 
foreign tax law were to contain rules substantially similar to those 
under section 267A is intended to limit the application of the imported 
mismatch rule to cases in which, had the foreign-to-foreign hybrid 
arrangement instead involved a specified party, section 267A would have 
applied to disallow the deduction. In other words, this requirement 
prevents the imported mismatch rule from applying to arrangements 
outside the general scope of section 267A, even if the arrangements are 
hybrid in nature and result in a D/NI (or similar) outcome. For 
example, in the case of a deductible payment of a foreign tax resident 
to a tax resident of a foreign country that does not impose an income 
tax, the deduction would generally not be a hybrid deduction--even 
though it may be made pursuant to a hybrid instrument--because the D/NI 
outcome would not be a result of hybridity. See section II.E of this 
Explanation of Provisions (requiring a link between hybridity and the 
D/NI outcome, for a specified payment to be a disqualified hybrid 
amount).
    Further, the proposed regulations include ``ordering'' and 
``funding'' rules to determine the extent that a hybrid deduction 
directly or indirectly offsets income attributable to a specified 
payment. In addition, the proposed regulations provide that certain 
payments made by non-specified parties the tax laws of which contain 
hybrid mismatch rules are taken into account when applying the ordering 
and funding rules. Together, these provisions are intended to 
coordinate proposed Sec.  1.267A-4 with foreign imported mismatch 
rules, in order to prevent the same hybrid deduction from resulting in 
deductions for non-hybrid payments being disallowed under imported 
mismatch rules in more than one jurisdiction.

J. Definitions of Interest and Royalty

1. Interest
    There are no generally applicable regulations or statutory 
provisions addressing when financial instruments are treated as debt 
for U.S. tax purposes or when a payment is interest. As a general 
matter, however, the factors that distinguish debt from equity are 
described in Notice 94-47, 1994-1 C.B. 357, and interest is defined as 
compensation for the use or forbearance of money. Deputy v. Dupont, 308 
U.S. 488 (1940).
    Using these principles, the proposed regulations define interest 
broadly to include interest associated with conventional debt 
instruments, other amounts treated as interest under the Code, as well 
as transactions that are indebtedness in substance although not in 
form. See proposed Sec.  1.267A-5(a)(12).
    In addition, in order to address certain structured transactions, 
the proposed regulations apply equally to ``structured payments.'' 
Proposed Sec.  1.267A-5(b)(5) defines structured payments to include a 
number of items such as an expense or loss predominately incurred in 
consideration of the time value of money in a transaction or series of 
integrated or related transactions in which a taxpayer secures the use 
of funds for a period of time. This approach is consistent with the 
rules treating such payments similarly to interest under Sec. Sec.  
1.861-9T and 1.954-2.
    The definitions of interest and structured payments also provide 
for adjustments to the amount of interest expense or structured 
payments, as applicable, to reflect the impact of derivatives that 
affect the economic yield or cost of funds of a transaction involving 
interest or structured payments. The definitions of interest and 
structured payments contained in the proposed regulations apply only 
for purposes of section 267A. However, solely for purposes of certain 
other provisions, similar definitions apply. For example, the 
definition of interest and structured payments under the proposed 
regulations is similar in scope to the definition of items treated 
similarly to interest under Sec.  1.861-9T for purposes of allocating 
and apportioning deductions under section 861 and similar to the items 
treated as interest expense for purposes of section 163(j) in proposed 
regulations under section 163(j).
    The Treasury Department and the IRS considered three options with 
respect to the definition of interest for purposes of section 267A. The 
first option considered was to not provide a definition of interest, 
and thus rely on general tax principles and case law to define interest 
for purposes of section 267A. While adopting this option might reduce 
complexity for some taxpayers, not providing an explicit definition of 
interest would create its own uncertainty as neither taxpayers nor the 
IRS might have a clear sense of what types of payments are treated as 
interest expense subject to disallowance under section 267A. Such 
uncertainty could increase burdens to the IRS and taxpayers by 
increasing the number of disputes about whether particular payments are 
interest for section 267A purposes. Moreover, this option could be 
distortive as it would provide an incentive to taxpayers to engage in 
transactions generating deductions economically similar to interest 
while asserting that such deductions are not described by existing 
principles defining interest expense. If successful, such strategies 
could allow taxpayers to avoid the application of section 267A through 
transactions that are similar to transactions involving interest.
    The second option considered would have been to adopt a definition 
of interest but limit the scope of the definition to cover only amounts 
associated with conventional debt instruments and amounts that are 
generally treated as interest for all purposes under the Code or 
regulations prior to the passage of the Act. This would be equivalent 
to only adopting the rule that is proposed in Sec.  1.267A-5(a)(12)(i) 
without also addressing structured payments, which are described in 
proposed Sec.  1.267A-5(b)(5). While this would clarify what would be 
deemed interest for purposes of section 267A, the Treasury Department 
and the IRS have determined that this approach would potentially 
distort future financing transactions. Some taxpayers would choose to 
use financial instruments and transactions that provide a similar 
economic result of using a conventional debt instrument, but would 
avoid the label of interest expense under such a definition, 
potentially enabling these taxpayers to avoid the application of 
section 267A. As a result, under this second approach, there would 
still be an incentive for taxpayers to engage in the type of avoidance 
transactions discussed in the first alternative.
    The final option considered and the one ultimately adopted in the 
proposed regulations is to provide a complete definition of interest 
that addresses all transactions that are commonly understood to produce 
interest expense, as well as structured payments that may have been 
entered into to avoid the application of section 267A. The proposed 
regulations also reduce taxpayer burden by adopting definitions of 
interest that have already been developed and administered in 
Sec. Sec.  1.861-9T and 1.954-2 and that have been proposed for 
purposes of section 163(j). The definition of interest provided in the 
proposed regulations applies only for purposes of section 267A and not 
for other purposes of the Code, such as section 904(d)(3).
    The Treasury Department and the IRS welcome comments on the 
definition of

[[Page 67621]]

interest for purposes of section 267A contained in the proposed 
regulations.
2. Royalty
    Section 267A does not define the term royalty and there is no 
universal definition of royalty under the Code. The Treasury Department 
and the IRS considered providing no definition for royalties. However, 
similar to the discussion in Section II.J.1 of this Explanation of 
Provisions with respect to the definition of interest, not providing a 
definition for royalties and relying instead on general tax principles 
could create uncertainty as neither taxpayers nor the IRS might have a 
clear sense of what types of payments are treated as royalties subject 
to disallowance under section 267A. Such uncertainty could increase 
burdens to the IRS and taxpayers with respect to disputes about whether 
particular payments are royalties for section 267A purposes.
    Instead, the Treasury Department and the IRS have determined that 
providing a definition of royalties would increase certainty, and 
therefore the proposed regulations define the term royalty for purposes 
of section 267A to include amounts paid or accrued as consideration for 
the use of, or the right to use, certain intellectual property and 
certain information concerning industrial, commercial or scientific 
experience. See proposed Sec.  1.267A-5(a)(16). The term does not 
include amounts paid or accrued for after-sales services, for services 
rendered by a seller to the purchaser under a warranty, for pure 
technical assistance, or for an opinion given by an engineer, lawyer or 
accountant. The definition of royalty provided in the proposed 
regulations applies only for purposes of section 267A and not for other 
purposes of the Code, such as section 904(d)(3).
    The definition of royalty is generally based on the definition used 
in tax treaties and, in particular, the definition incorporated into 
Article 12 of the 2006 U.S. Model Income Tax Treaty. This definition is 
also generally consistent with the language of section 861(a)(4). In 
addition, similar to the approach in the technical explanation to 
Article 12 of the 2006 U.S. Model Income Tax Treaty, the proposed 
regulations provide certain circumstances where payments are not 
treated as paid or accrued in consideration for the use of information 
concerning industrial, commercial or scientific experience. By using 
definitions that have already been developed and administered in other 
contexts, the proposed regulations provide an approach that reduces 
taxpayer burdens and uncertainty. The Treasury Department and the IRS 
welcome comments on the definition of royalty for purposes of section 
267A contained in the proposed regulations.

K. Miscellaneous Issues

1. Effect of Foreign Currency Gain or Loss
    The proposed regulations provide that foreign currency gain or loss 
recognized under section 988 is not separately taken into account under 
section 267A. See proposed Sec.  1.267A-5(b)(2). Rather, foreign 
currency gain or loss recognized with respect to a specified payment is 
taken into account under section 267A only to the extent that the 
specified payment is in respect of accrued interest or an accrued 
royalty for which a deduction is disallowed under section 267A. Thus, 
for example, a section 988 loss recognized with respect to a specified 
payment of interest is not separately taken into account under section 
267A (even though under the tax law of the tax resident to which the 
specified payment is made the tax resident does not include in income 
an amount corresponding to the section 988 loss, as the specified 
payment is made in the tax resident's functional currency).
    The Treasury Department and the IRS recognize that additional rules 
addressing the effect of different foreign currencies may be necessary. 
For example, a hybrid deduction for purposes of the imported mismatch 
rule may be denominated in a different currency than a specified 
payment, in which case a translation rule may be necessary to determine 
the amount of the specified payment that is subject to the imported 
mismatch rule. The Treasury Department and the IRS request comments on 
foreign currency rules, including any rules regarding the translation 
of amounts between currencies, for purposes of the proposed regulations 
under sections 245A and 267A.
2. Payments by U.S. Taxable Branches
    Certain expenses incurred by a nonresident alien or foreign 
corporation are allowed as deductions under sections 873(a) and 882(c) 
in determining that person's effectively connected income. To the 
extent the deductions arise from transactions involving certain hybrid 
or branch arrangements, the deductions should be disallowed under 
section 267A, as discussed in section II.B of this Explanation of 
Provisions. The proposed regulations do so by (i) treating a U.S. 
taxable branch (which includes a permanent establishment of a foreign 
person) as a specified party, and (ii) providing rules regarding 
interest or royalties considered paid or accrued by a U.S. taxable 
branch, solely for purposes of section 267A (and thus not for other 
purposes, such as chapter 3 of the Code). See proposed Sec.  1.267A-
5(b)(3). The effect of this approach is that interest or royalties 
considered paid or accrued by a U.S. taxable branch are specified 
payments that are subject to the rules of proposed Sec. Sec.  1.267A-1 
through 1.267A-4. See also proposed Sec.  1.267A-6(c), Example 4.
    In general, a U.S. taxable branch is considered to pay or accrue 
any interest or royalties allocated or apportioned to effectively 
connected income of the U.S. taxable branch. See proposed Sec.  1.267A-
5(b)(3)(i). However, if a U.S. taxable branch constitutes a U.S. 
permanent establishment of a treaty resident, then the U.S. permanent 
establishment is considered to pay or accrue the interest or royalties 
deductible in computing its business profits. Although interest paid by 
a U.S. taxable branch may be subject to withholding tax as determined 
under section 884(f)(1)(A) and Sec.  1.884-4, those rules are not 
relevant for purposes of section 267A.
    The proposed regulations also provide rules to identify the manner 
in which a specified payment of a U.S. taxable branch is considered 
made. See proposed Sec.  1.267A-5(b)(3)(ii). Absent such rules, it 
might be difficult to determine whether the specified payment is made 
pursuant to a hybrid or branch arrangement (for example, made pursuant 
to a hybrid transaction or to a reverse hybrid). However, these rules 
regarding the manner in which a specified payment is made do not apply 
to interest or royalties deemed paid by a U.S. permanent establishment 
in connection with inter-branch transactions that are permitted to be 
taken into account under certain U.S. tax treaties--such payments, by 
definition, constitute deemed branch payments (subject to disallowance 
under proposed Sec.  1.267A-2(c)) and are therefore made pursuant to a 
branch arrangement.
3. Coordination With Other Provisions
    Proposed Sec.  1.267A-5(b)(1) coordinates the application of 
section 267A with other provisions of the Code and regulations that 
affect the deductibility of interest and royalties. This rule provides 
that, in general, section 267A applies after the application of other 
provisions of the Code and regulations. For example, a specified 
payment is subject to section 267A for the taxable year for which a 
deduction for the payment would

[[Page 67622]]

otherwise be allowed. Thus, if a deduction for an accrued amount is 
deferred under section 267(a) (in certain cases, deferring a deduction 
for an amount accrued to a related foreign person until paid), then the 
deduction is tested for disallowance under section 267A for the taxable 
year in which the amount is paid. Absent such a rule, an accrued amount 
for which a deduction is deferred under section 267(a) could constitute 
a disqualified hybrid amount even though the amount will be included in 
the specified recipient's income when actually paid. This coordination 
rule also provides that section 267A applies to interest or royalties 
after taking into account provisions that could otherwise 
recharacterize such amounts, such as Sec.  1.894-1(d)(2).
4. E&P Reduction
    Proposed Sec.  1.267A-5(b)(4) provides that the disallowance of a 
deduction under section 267A does not affect whether or when the amount 
paid or accrued that gave rise to the deduction reduces earnings and 
profits of a corporation. Thus, a corporation's earnings and profits 
may be reduced as a result of a specified payment for which a deduction 
is disallowed under section 267A. This is consistent with the approach 
in the context of other disallowance rules. See Sec.  1.312-7(b)(1) 
(``A loss . . . may be recognized though not allowed as a deduction (by 
reason, for example, of the operation of sections 267 and 1211 . . .) 
but the mere fact that it is not allowed does not prevent a decrease in 
earnings and profits by the amount of such disallowed loss.''); Luckman 
v. Comm'r, 418 F.2d 381, 383-84 (7th Cir. 1969) (``[T]rue expenses 
incurred by the corporation reduce earnings and profits despite their 
nondeductibility from current income for tax purposes.'').
5. De Minimis Exception
    The proposed regulations provide a de minimis exception to make the 
rules more administrable. See proposed Sec.  1.267A-1(c). As a result 
of this exception, a specified party is excepted from the application 
of section 267A for any taxable year for which the sum of its interest 
and royalty deductions (plus interest and royalty deductions of any 
related specified parties) is below $50,000. This rule applies based on 
any interest or royalty deductions, regardless of whether the 
deductions would be disallowed under section 267A. In addition, for 
purposes of this rule, specified parties that are related are treated 
as a single specified party.
    The Treasury Department and the IRS welcome comments on the de 
minimis exception and whether another threshold would be more 
appropriate to implement the purposes of section 267A.

L. Interaction With Withholding Taxes and Income Tax Treaties

    The determination of whether a deduction for a specified payment is 
disallowed under section 267A is made without regard to whether the 
payment is subject to withholding under section 1441 or 1442 or is 
eligible for a reduced rate of tax under an income tax treaty. Since 
the U.S. tax characterization of the payment prevails in determining 
the treaty rate for interest or royalties, regardless of whether the 
payment is made pursuant to a hybrid transaction, the proposed 
regulations will generally result in the disallowance of a deduction 
but treaty benefits may still be claimed, as long as the recipient is 
the beneficial owner of the payment and otherwise eligible for treaty 
benefits. On the other hand, if interest or royalties are paid to a 
fiscally transparent entity that is a reverse hybrid, as defined in 
proposed Sec.  1.267A-2(d), the payment generally will not be 
deductible under the proposed regulations if the investor does not 
derive the payment, and will not be eligible for treaty benefits if the 
interest holder under Sec.  1.894-1(d) does not derive the payment. The 
proposed regulations will only apply, however, if the investor is 
related to the specified party, whereas the reduced rate under the 
treaty may be denied without regard to whether the interest holder is 
related to the payer of the interest or royalties.
    Certain U.S. income tax treaties also address indirectly the branch 
mismatch rules under proposed Sec.  1.267A-2(e). Special rules, 
generally in the limitation on benefits articles of income tax 
treaties, increase the tax treaty rate for interest and royalties to 15 
percent (even if otherwise not taxable under the relevant treaty 
article) if the amount paid to a permanent establishment of the treaty 
resident is subject to minimal tax, and the foreign corporation that 
derives and beneficially owns the payment is a resident of a treaty 
country that excludes or otherwise exempts from gross income the 
profits attributable to the permanent establishment to which the 
payment was made.

III. Information Reporting Under Sections 6038, 6038A, and 6038C

    Under section 6038(a)(1), U.S. persons that control foreign 
business entities must file certain information returns with respect to 
those entities, which includes information listed in section 
6038(a)(1)(A) through (a)(1)(E), as well as information that ``the 
Secretary determines to be appropriate to carry out the provisions of 
this title.'' Section 6038A similarly requires 25-percent foreign-owned 
domestic corporations (reporting corporations) to file certain 
information returns with respect to those corporations, including 
information related to transactions between the reporting corporation 
and each foreign person which is a related party to the reporting 
corporation. Section 6038C imposes the same reporting requirements on 
certain foreign corporations engaged in a U.S. trade or business (also, 
a reporting corporation).
    The proposed regulations provide that a specified payment for which 
a deduction is disallowed under section 267A, as well as hybrid 
dividends and tiered hybrid dividends under section 245A, must be 
reported on the appropriate information reporting form in accordance 
with sections 6038 and 6038A. See proposed Sec. Sec.  1.6038-2(f)(13) 
and (14), 1.6038-3(g)(3), and 1.6038A-2(b)(5)(iii).

IV. Sections 1503(d) and 7701--Application to Domestic Reverse Hybrids

A. Overview

1. Dual Consolidated Loss Rules
    Congress enacted section 1503(d) to prevent the ``double dipping'' 
of losses. See S. Rep. 313, 99th Cong., 2d Sess., at 419-20 (1986). The 
Senate Report explains that ``losses that a corporation uses to offset 
foreign tax on income that the United States does not subject to tax 
should not also be used to reduce any other corporation's U.S. tax.'' 
Id. Section 1503(d) and the regulations thereunder generally provide 
that, subject to certain exceptions, a dual consolidated loss of a 
corporation cannot reduce the taxable income of a domestic affiliate (a 
``domestic use''). See Sec. Sec.  1.1503(d)-2 and 1.1503-4(b). Section 
1.1503(d)-1(b)(5) defines a dual consolidated loss as a net operating 
loss of a dual resident corporation or the net loss attributable to a 
separate unit (generally defined as either a foreign branch or an 
interest in a hybrid entity). See Sec.  1.1503(d)-1(b)(4).
    The general prohibition against the domestic use of a dual 
consolidated loss does not apply if, pursuant to a ``domestic use 
election,'' the taxpayer certifies that there has not been and will not 
be a ``foreign use'' of the dual consolidated loss during a 
certification period. See Sec.  1.1503(d)-6(d). If a foreign use or 
other triggering event occurs during the certification period, the dual 
consolidated loss is recaptured. A

[[Page 67623]]

foreign use occurs when any portion of the dual consolidated loss is 
made available to offset the income of a foreign corporation or the 
direct or indirect owner of a hybrid entity (generally non-dual 
inclusion income). See Sec.  1.1503(d)-3(a)(1). Other triggering events 
include certain transfers of the stock or assets of a dual resident 
corporation, or the interests in or assets of a separate unit. See 
Sec.  1.1503(d)-6(e).
    The regulations include a ``mirror legislation'' rule that, in 
general, prevents a domestic use election when a foreign jurisdiction 
has enacted legislation similar to section 1503(d) that denies any 
opportunity for a foreign use of the dual consolidated loss. See Sec.  
1.1503(d)-3(e). As a result, the existence of mirror legislation may 
prevent the dual consolidated loss from being put to a domestic use 
(due to the domestic use limitation) or to a foreign use (due to the 
foreign ``mirror legislation'') such that the loss becomes 
``stranded.'' In such a case, the regulations contemplate that the 
taxpayer may enter into an agreement with the United States and the 
foreign country (for example, through the competent authorities) 
pursuant to which the losses are used in only one country. See Sec.  
1.1503(d)-6(b).
2. Entity Classification Rules
    Sections 301.7701-1 through 301.7701-3 classify a business entity 
with two or more members as either a corporation or a partnership, and 
a business entity with a single owner as either a corporation or a 
disregarded entity. Certain domestic business entities, such as limited 
liability companies, are classified by default as partnerships (if they 
have more than one member) or as disregarded entities (if they have 
only one owner) but are eligible to elect for federal tax purposes to 
be classified as corporations. See Sec.  301.7701-3(b)(1).
B. Domestic Reverse Hybrids
    The Treasury Department and the IRS are aware that structures 
involving domestic reverse hybrids have been used to obtain double-
deduction outcomes because they were not subject to limitation under 
current section 1503(d) regulations. A domestic reverse hybrid 
generally refers to a domestic business entity that elects under Sec.  
301.7701-3(c) to be treated as a corporation for U.S. tax purposes, but 
is treated as fiscally transparent under the tax law of its investors. 
In these structures, a foreign parent corporation typically owns the 
majority of the interests in the domestic reverse hybrid. Domestic 
reverse hybrid structures can lead to double-deduction outcomes 
because, for example, deductions incurred by the domestic reverse 
hybrid can be used (i) under U.S. tax law to offset income that is not 
subject to tax in the foreign parent's country, such as income of 
domestic corporations with which the domestic reverse hybrid files a 
U.S. consolidated return, and (ii) under the foreign parent's tax law 
to offset income not subject to U.S. tax, such as income of the foreign 
parent other than the income (if any) of the domestic reverse hybrid. 
Taxpayers take the position that these structures are not subject to 
the current section 1503(d) regulations because the domestic reverse 
hybrid is neither a dual resident corporation (because it is not 
subject to tax on a residence basis or on its worldwide income in the 
foreign parent country) nor a separate unit of a domestic corporation.
    A comment on regulations under section 1503(d) that were proposed 
in 2005 asserted that this result is inconsistent with the policies 
underlying section 1503(d), which was adopted, in part, to ensure that 
domestic corporations were not put at a competitive disadvantage as 
compared to foreign corporations through the use of certain inbound 
acquisition structures. See TD 9315. The comment suggested that the 
scope of the final regulations be broadened to treat such entities as 
separate units, the losses of which are subject to the restrictions of 
section 1503(d). Id.
    In response to this comment, the preamble to the 2007 final dual 
consolidated loss regulations stated that the Treasury Department and 
the IRS acknowledged that this type of structure results in a double 
dip similar to that which Congress intended to prevent through the 
adoption of section 1503(d). The final regulations did not address 
these structures, however, because the Treasury Department and the IRS 
determined at that time that a domestic reverse hybrid was neither a 
dual resident corporation nor a separate unit and, therefore, was not 
subject to section 1503(d). See TD 9315. The preamble noted, however, 
that the Treasury Department and the IRS would continue to study these 
and similar structures.
    The Treasury Department and the IRS have determined that these 
structures are inconsistent with the principles of section 1503(d) and, 
as a result, raise significant policy concerns. Accordingly, the 
proposed regulations include rules under sections 1503(d) and 7701 to 
prevent the use of these structures to obtain a double-deduction 
outcome. The proposed regulations require, as a condition to a domestic 
entity electing to be treated as a corporation under Sec.  301.7701-
3(c), that the domestic entity consent to be treated as a dual resident 
corporation for purposes of section 1503(d) (such an entity, a 
``domestic consenting corporation'') for taxable years in which two 
requirements are satisfied. See proposed Sec.  301.7701-3(c)(3). The 
requirements are intended to restrict the application of section 
1503(d) to cases in which it is likely that losses of the domestic 
consenting corporation could result in a double-deduction outcome.
    The requirements are satisfied if (i) a ``specified foreign tax 
resident'' (generally, a body corporate that is a tax resident of a 
foreign country) under its tax law derives or incurs items of income, 
gain, deduction, or loss of the domestic consenting corporation, and 
(ii) the specified foreign tax resident is related to the domestic 
consenting corporation (as determined under section 267(b) or 707(b)). 
See proposed Sec.  1.1503(d)-1(c). For example, the requirements are 
satisfied if a specified foreign tax resident directly owns all the 
interests in the domestic consenting corporation and the domestic 
consenting corporation is fiscally transparent under the specified 
foreign tax resident's tax law. In addition, an item of the domestic 
consenting corporation for a particular taxable year is considered 
derived or incurred by the specified tax resident during that year even 
if, under the specified foreign tax resident's tax law, the item is 
recognized in, and derived or incurred by the specified foreign tax 
resident in, a different taxable year.
    Further, if a domestic entity filed an election to be treated as a 
corporation before December 20, 2018 such that the entity was not 
required to consent to be treated as a dual resident corporation, then 
the entity is deemed to consent to being treated as a dual resident 
corporation as of its first taxable year beginning on or after the end 
of a 12-month transition period. This deemed consent can be avoided if 
the entity elects, effective before its first taxable year beginning on 
or after the end of the transition period, to be treated as a 
partnership or disregarded entity such that it ceases to be a 
corporation for U.S. tax purposes. For purposes of such an election, 
the 60 month limitation under Sec.  301.7701-3(c)(1)(iv) is waived.
    Finally, the proposed regulations provide that the mirror 
legislation rule does not apply to dual consolidated losses of a 
domestic consenting corporation. See proposed Sec.  1.1503(d)-3(e)(3). 
This exception is intended to minimize cases in which dual

[[Page 67624]]

consolidated losses could be ``stranded'' when, for example, the 
foreign parent jurisdiction has adopted rules similar to the 
recommendations in Chapter 6 of the Hybrid Mismatch Report. The 
exception does not apply to dual consolidated losses attributable to 
separate units because, in such cases, the United States is the parent 
jurisdiction and the dual consolidated loss rules should neutralize the 
double-deduction outcome.

V. Triggering Event Exception for Compulsory Transfers

    As noted in section IV.A.1 of this Explanation of Provisions, 
certain triggering events require a dual consolidated loss that is 
subject to a domestic use election to be recaptured and included in 
income. The dual consolidated loss regulations also include various 
exceptions to these triggering events, including an exception for 
compulsory transfers involving foreign governments. See Sec.  
1.1503(d)-6(f)(5).
    A comment on the 2007 final dual consolidated loss regulations 
stated that the policies underlying the triggering event exception for 
compulsory transfers involving foreign governments apply equally to 
compulsory transfers involving the United States government. 
Accordingly, the comment requested guidance under Sec.  1.1503(d)-
3(c)(9) to provide that the exception is not limited to foreign 
governments. The comment suggested, as an example, that the exception 
should apply to a divestiture of a hybrid entity engaged in proprietary 
trading pursuant to the ``Volcker Rule'' contained in the Dodd-Frank 
Wall Street Reform and Consumer Protection Act, Public Law 111-203 
(2010).
    The Treasury Department and the IRS agree with this comment and, 
accordingly, the proposed regulations modify the compulsory transfer 
triggering event exception such that it will also apply with respect to 
the United States government.

VI. Disregarded Payments Made to Domestic Corporations

    As discussed in sections II.D.2 and 3 of this Explanation of 
Provisions, the proposed regulations under section 267A address D/NI 
outcomes resulting from actual and deemed payments of interest and 
royalties that are regarded for U.S. tax purposes but disregarded for 
foreign tax purposes. The proposed regulations under section 267A do 
not, however, address similar structures involving payments to domestic 
corporations that are regarded for foreign tax purposes but disregarded 
for U.S. tax purposes.
    For example, USP, a domestic corporation that is the parent of a 
consolidated group, borrows from a bank to fund the acquisition of the 
stock of FT, a foreign corporation that is tax resident of Country X. 
USP contributes the loan proceeds to USS, a newly formed domestic 
corporation that is a member of the USP consolidated group, in exchange 
for all the stock of USS. USS then forms FDE, a disregarded entity that 
is tax resident of Country X, USS lends the loan proceeds to FDE, and 
FDE uses the proceeds to acquire the stock of FT. For U.S. tax 
purposes, USP claims a deduction for interest paid on the bank loan, 
and USS does not recognize interest income on interest payments made to 
it from FDE because the payments are disregarded. For Country X tax 
purposes, the interest paid from FDE to USS is regarded and gives rise 
to a loss that can be surrendered (or otherwise used, such as through a 
consolidation regime) to offset the operating income of FT.
    Under the current section 1503(d) regulations, the loan from USS to 
FDE does not result in a dual consolidated loss attributable to USS's 
interest in FDE because interest paid on the loan is not regarded for 
U.S. tax purposes; only items that are regarded for U.S. tax purposes 
are taken into account for purposes of determining a dual consolidated 
loss. See Sec.  1.1503(d)-5(c)(1)(ii). In addition, the regarded 
interest expense of USP is not attributed to USS's interest in FDE 
because only regarded items of USS, the domestic owner of FDE, are 
taken into account for purposes of determining a dual consolidated 
loss. Id. The result would generally be the same, however, even if USS, 
rather than USP, were the borrower on the bank loan. See Sec.  
1.1503(d)-7(c), Example 23.
    The Treasury Department and the IRS have determined that these 
transactions raise significant policy concerns that are similar to 
those relating to the D/NI outcomes addressed by sections 245A(e) and 
267A, and the double-deduction outcomes addressed by section 1503(d). 
The Treasury Department and the IRS are studying these transactions and 
request comments.

VII. Applicability Dates

    Under section 7805(b)(2), and consistent with the applicability 
date of section 245A, proposed Sec.  1.245A(e)-1 applies to 
distributions made after December 31, 2017. Under section 7805(b)(2), 
proposed Sec. Sec.  1.267A-1 through 1.267A-6 generally apply to 
specified payments made in taxable years beginning after December 31, 
2017. This applicability date is consistent with the applicability date 
of section 267A. The Treasury Department and the IRS therefore expect 
to finalize such provisions by June 22, 2019. See section 7805(b)(2). 
However if such provisions are finalized after June 22, 2019, then the 
Treasury Department and the IRS expect that such provisions will apply 
only to taxable years ending on or after December 20, 2018. See section 
7805(b)(1)(B).
    As provided in proposed Sec.  1.267A-7(b), certain rules, such as 
the disregarded payment and deemed branch payment rules as well as the 
imported mismatch rule, apply to specified payments made in taxable 
years beginning on or after December 20, 2018. See section 
7805(b)(1)(B).
    Proposed Sec. Sec.  1.6038-2, 1.6038-3, and 1.6038A-2, which 
require certain reporting regarding deductions disallowed under section 
267A, as well as hybrid dividends and tiered hybrid dividends under 
section 245A, apply with respect to information for annual accounting 
periods or tax years, as applicable, beginning on or after December 20, 
2018. See section 7805(b)(1)(B).
    Proposed Sec. Sec.  1.1503(d)-1 and -3, treating domestic 
consenting corporations as dual resident corporations, apply to taxable 
years ending on or after December 20, 2018. See section 7805(b)(1)(B).
    Proposed Sec.  1.1503(d)-6, amending the compulsory transfer 
triggering event exception, applies to transfers that occur on or after 
December 20, 2018, but taxpayers may apply the rules to earlier 
transfers. See section 7805(b)(1)(B).
    Proposed Sec.  301.7701-3(a) and (c)(3) apply to a domestic 
eligible entity that on or after December 20, 2018 files an election to 
be classified as an association (regardless of whether the election is 
effective before December 20, 2018). These provisions also apply to 
certain domestic eligible entities the interests in which are 
transferred or issued on or after December 20, 2018. See section 
7805(b)(1)(B).

Special Analyses

I. Regulatory Planning and Review

    Executive Orders 13771, 13563, and 12866 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits, including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity. Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, reducing costs,

[[Page 67625]]

harmonizing rules, and promoting flexibility. The preliminary E.O. 
13771 designation for this proposed rulemaking is regulatory.
    The proposed regulations have been designated by the Office of 
Management and Budget's Office of Information and Regulatory Affairs 
(OIRA) as subject to review under Executive Order 12866 pursuant to the 
Memorandum of Agreement (April 11, 2018) between the Treasury 
Department and the Office of Management and Budget regarding review of 
tax regulations (``MOA''). OIRA has determined that the proposed 
rulemaking is economically significant and subject to review under E.O. 
12866 and section 1(c) of the Memorandum of Agreement. Accordingly, the 
proposed regulations have been reviewed by the Office of Management and 
Budget.

A. Background

    Hybrid arrangements include both ``hybrid entities'' and ``hybrid 
instruments.'' A hybrid entity is generally an entity which is treated 
as a flow-through or disregarded entity for U.S. tax purposes but as a 
corporation for foreign tax purposes or vice versa. Hybrid instruments 
are financial instruments that share characteristics of both debt and 
equity and are treated as debt for U.S. tax purposes and equity in the 
foreign jurisdiction or vice versa.
    Before the Act, U.S. subsidiaries of foreign-based multinational 
enterprises could employ cross-border hybrid arrangements as legal tax-
avoidance techniques by exploiting differences in tax treatment across 
jurisdictions. These arrangements allowed taxpayers to claim tax 
deductions in the United States without a corresponding inclusion in 
another jurisdiction.
    The United States has a check-the-box regulatory provision, under 
which some taxpayers can choose whether they are treated as 
corporations, where they may face a separate entity level tax, or as 
partnerships, where there is no such separate entity tax (but rather 
only owner-level tax), under the U.S. tax code. This choice allows 
taxpayers the ability to become hybrid entities that are viewed as 
corporations in one jurisdiction, but not in another. For example, a 
foreign parent could own a domestic subsidiary limited liability 
partnership (LLP) that, under the check-the-box rules, elects to be 
treated as a corporation under U.S. tax law. However, this subsidiary 
could be viewed as a partnership under foreign tax law. The result is 
that the domestic subsidiary could be entitled to a deduction for U.S. 
tax purposes for making interest payments to the foreign parent, but 
the foreign country would see a payment between a partnership and a 
partner, and therefore would not tax the interest income. That is, the 
corporate structure would enable the business entity to avoid paying 
U.S. tax on the interest by allowing a deduction attributable to an 
intra-group loan, despite the interest income never being included 
under foreign tax law.
    In addition, there are hybrid instruments, which share 
characteristics of both debt and equity. Because of these shared 
characteristics, countries may be inconsistent in their treatment of 
such instruments. One example is perpetual debt, which many countries 
treat as debt, but the United States treats as equity. If a foreign 
affiliate of a U.S.-based multinational issued perpetual debt to a U.S. 
holder, the interest payments would be tax deductible in a foreign 
jurisdiction that treats the instrument as debt, while the payments are 
treated as dividends in the United States and potentially eligible for 
a dividends received deduction (DRD).
    The Act adds section 245A(e) to the Code to address issues of 
hybridity by introducing a hybrid dividends provision, which disallows 
the DRD for any dividend received by a U.S. shareholder from a 
controlled foreign corporation if the dividend is a hybrid dividend. 
The statute defines a hybrid dividend as an amount received from a 
controlled foreign corporation for which a deduction would be allowed 
under section 245A(a) and for which the controlled foreign corporation 
received a deduction or other tax benefit in a foreign country. Hybrid 
dividends between controlled foreign corporations with a common U.S. 
shareholder are treated as subpart F income.
    The Act also adds section 267A of the Code to deny a deduction for 
any disqualified related party amount paid or accrued as a result of a 
hybrid transaction or by, or to, a hybrid entity. The statute defines a 
disqualified related party amount as any interest or royalty paid or 
accrued to a related party where there is no corresponding inclusion to 
the related party in the other tax jurisdiction or the related party is 
allowed a deduction with respect to such amount in the other tax 
jurisdiction. The statute's definition of a hybrid transaction is any 
transaction where there is a mismatch in tax treatment between the U.S. 
and the other foreign jurisdiction. Similarly, a hybrid entity is any 
entity which is treated as fiscally transparent for U.S. tax purposes 
but not for purposes of the foreign tax jurisdiction, or vice versa.

B. Overview

    The hybrids provisions in the Act and the proposed regulations are 
anti-abuse measures. Taxpayers have been taking aggressive tax 
positions to take advantage of tax treatment mismatches between 
jurisdictions in order to achieve favorable tax outcomes at the 
detriment of tax revenues (see OECD/G20 Hybrid Mismatch Report, October 
2015 and OECD/G20 Branch Mismatch Report, July 2017). The statute and 
the proposed regulations serve to conform the U.S. tax system to 
recently agreed-upon international tax principles (see OECD/G20 Hybrids 
Mismatch Report, October 2015 and OECD/G20 Branch Mismatch Report, July 
2017), consistent with statutory intent, while protecting U.S. 
interests and the U.S. tax base. International tax coordination is 
particularly advantageous in the context of hybrids as it has the 
potential to greatly curb opportunities for hybrid arrangements, while 
avoiding double taxation. The anticipated effect of the statute and 
proposed regulations is a reduction in tax revenue loss due to hybrid 
arrangements, at the cost of an increase in compliance burden for a 
limited number of sophisticated taxpayers, as explained below.

C. Need for the Proposed Regulations

    Because the Act introduced new sections to the Code to address 
hybrid entities and hybrid instruments, a large number of the relevant 
terms and necessary calculations that taxpayers are currently required 
to apply under the statute can benefit from greater specificity. 
Taxpayers will lack clarity on which types of arrangements are subject 
to the statute without the additional interpretive guidance and 
clarifications contained in the proposed regulations. This lack of 
clarity could lead to a shifting of corporate income overseas through 
hybrid arrangements, further eroding U.S. tax revenues. Without 
accompanying rules to cover branches, structured arrangements, imported 
mismatches, and similar structures, the statute would be extremely easy 
to avoid, a pathway that is contrary to Congressional intent. It could 
also lead to otherwise similar taxpayers interpreting the statute 
differently, distorting the equity of tax treatment for otherwise 
similarly situated taxpayers. Finally, the lack of clarity could cause 
some taxpayers unnecessary compliance burden if they misinterpret the 
statute.

[[Page 67626]]

D. Economic Analysis

1. Baseline
    The Treasury Department and the IRS have assessed the benefits and 
costs of the proposed regulations relative to a no-action baseline 
reflecting anticipated tax-related behavior and other economic behavior 
in the absence of the proposed regulations.
    The baseline includes the Act, which effectively cut the top 
statutory corporate income tax rate from 35 to 21 percent. This change 
lowered the value of using hybrid arrangements for multinational 
corporations, because the value of such arrangements is proportional to 
the tax they allow the corporation to avoid. As such, some firms with 
an incentive to set up hybrid arrangements prior to the Act would no 
longer find it profitable to maintain these arrangements. The Act also 
modified section 163(j), and regulations interpreting this provision 
are expected to be finalized soon, which together further limit the 
deductibility of interest payments. These statutory and regulatory 
changes further curb the incentive to set up and maintain hybrid 
arrangements for multinational corporations, since interest payments 
are a primary vehicle through which hybrid arrangements generated 
deductions prior to the Act. Further, prior to the Act, the Treasury 
Department and the IRS issued a series of regulations that reduced or 
eliminated the incentive for multinational corporations to invert, or 
change their tax residence to avoid U.S. taxes (including setting up 
some hybrid arrangements). As a result, under the baseline, the value 
of hybrid arrangements reflects the existing regulatory framework and 
the Act and its associated soon-to-be-finalized regulations, all of 
which strongly affect the value of hybrid arrangements as a tax 
avoidance technique.
2. Anticipated Costs and Benefits
i. Economic Effects
    The Treasury Department has determined that the discretionary non-
revenue impacts of the proposed hybrid regulations will reduce U.S. 
Gross Domestic Product (GDP) by less than $100 million per year 
($2018).
    To evaluate this effect, the Treasury Department considered the 
share of interest deductions that would be disallowed by the proposed 
regulations. Using Treasury Department models applied to confidential 
2016 tax data, the Treasury Department calculated the average effective 
tax rate for potentially affected taxpayers under a range of levels of 
interest payment deductibility, including the level of deductibility 
under the Act without the proposed regulations. The difference between 
the estimated effective tax rate under the Act and without the 
discretionary elements of the proposed regulations and the range of 
estimated effective tax rates that include the proposed regulations 
provides a range of estimates of the net increase in the effective tax 
rate due to the discretion exercised in the proposed regulations. The 
Treasury Department next applied an elasticity of taxable income to the 
range of estimated increases in the effective tax rate to estimate the 
reduction in taxable income for each of the affected taxpayers in the 
sample. The Treasury Department then examined a range of estimates of 
the relationship between the change in taxable income and the real 
change in economic activity. Finally, the Treasury Department 
extrapolated the results through 2027.
    The Treasury Department concludes from this evaluation that the 
discretionary aspects of the proposed rules will reduce GDP annually by 
less than $100 million ($2018). The projected effects reflect the 
proposed regulations alone and do not include non-revenue economic 
effects stemming from the Act in the absence of the proposed 
regulations. More specifically, the analysis did not estimate the 
impacts of the statutory requirement that hybrid dividends shall be 
treated as subpart F income of the receiving controlled foreign 
corporations for purposes of section 951(a)(1)(A) for the taxable year 
and shall not be permitted a foreign tax credit. See section 245A(e).
    The Treasury Department solicits comments on the methodology used 
to evaluate the non-revenue economic effects of the proposed 
regulations and anticipates that further analysis will be provided at 
the final rule stage.
ii. Anticipated Costs and Benefits of Specific Provisions
a. Section 245A(e)
    Section 245A(e) applies in certain cases in which a CFC pays a 
hybrid dividend, which is a dividend paid by the CFC for which the CFC 
received a deduction or other tax benefit under foreign tax law (a 
hybrid deduction). The proposed regulations provide rules for 
identifying and tracking such hybrid deductions. These rules set forth 
common standards for identifying hybrid deductions and therefore 
clarify what is deemed a hybrid dividend by the statute and ensure 
equitable tax treatment of otherwise similar taxpayers.
    The proposed regulations also address timing differences to ensure 
that there is parity between economically similar transactions. Absent 
such rules, similar transactions may be treated differently due to 
timing differences. For example, if a CFC paid out a dividend in a 
given taxable year for which it received a deduction or other tax 
benefit in a prior taxable year, the taxpayer might claim the dividend 
is not a hybrid dividend, since the taxable year in which the dividend 
is paid for U.S. tax purposes and the year in which the tax benefit is 
received do not overlap. Absent rules, such as the proposed 
regulations, the purpose of section 245A(e) might be avoided and 
economically similar transactions might be treated differently.
    Finally, these rules excuse certain taxpayers from having to track 
hybrid deductions (namely taxpayers without a sufficient connection to 
a section 245A(a) dividends received deduction). The utility of 
requiring these taxpayers to track hybrid deductions would be 
outweighed by the burdens of doing so. The proposed regulations reduce 
the compliance burden on taxpayers that are not directly dealing with 
hybrid dividends.
b. Section 267A
    Section 267A disallows a deduction for interest or royalties paid 
or accrued in certain transactions involving a hybrid arrangement. 
Congress intended this provision to address cases in which the taxpayer 
is provided a deduction under U.S. tax law, but the payee does not have 
a corresponding income inclusion under foreign tax law, dubbed a 
``deduction/no-inclusion outcome'' (D/NI outcome). See Senate 
Explanation, at 384. This affects taxpayers that attempt to use hybrid 
arrangements to strip income out of the United States taxing 
jurisdiction.
    The proposed regulations disallow a deduction under section 267A 
only to the extent that the D/NI outcome is a result of a hybrid 
arrangement. Note that under the statute but without the proposed 
regulations, a deduction would be disallowed simply if a D/NI outcome 
occurs and a hybrid arrangement exists (see section II.E of the 
Explanation of Provisions). For example, a royalty payment made to a 
hybrid entity in the U.K. qualifying for a low tax rate under the U.K. 
patent box regime could be denied a deduction in the U.S. under the 
statute. However, the low U.K. rate is a result of the lower tax rate 
on patent box income and not a result of any hybrid arrangement. In 
this example, there is no link between hybridity and the D/NI outcome, 
since it is the U.K. patent box regime that

[[Page 67627]]

yields the D/NI outcome and the low U.K. patent box rate is available 
to taxpayers regardless of whether they are organized as hybrid 
entities or not. The proposed regulations limit the application of 
section 267A to cases where the D/NI outcome occurs as a result of 
hybrid arrangements and not due to a generally applicable feature of 
the jurisdiction's tax system.
    The proposed regulations also provide several exceptions to section 
267A in order to refine the scope of the provision and minimize burdens 
on taxpayers. First, the proposed regulations generally exclude from 
section 267A payments that are included in a U.S. tax resident's or 
U.S. taxable branch's income or are taken into account for purposes of 
the subpart F or global intangible low-taxed income (GILTI) provisions. 
While the exception for income taken into account for purposes of 
subpart F is in the statute, the proposed regulations expand the 
exception to cover GILTI. This avoids potential double taxation on that 
income. In addition, as a refinement compared with the statute, the 
extent to which a payment is taken into account under subpart F is 
determined without regard to allocable deductions or qualified 
deficits. The proposed regulations also provide a de minimis rule that 
excepts small taxpayers from section 267A, minimizing the burden on 
small taxpayers.
    Finally, the proposed regulations address a comprehensive set of 
transactions that give rise to D/NI outcomes. The statute, as written, 
does not apply to certain hybrid arrangements, including branch 
arrangements and certain reverse hybrids, as described above (see 
section II.D of the Explanation of Provisions). The exclusion of these 
arrangements could have large economic and fiscal consequences due to 
taxpayers shifting tax planning towards these arrangements to avoid the 
new anti-abuse statute. The proposed regulations close off this 
potential avenue for additional tax avoidance by applying the rules of 
section 267A to branch mismatches, reverse hybrids, certain 
transactions with unrelated parties that are structured to achieve D/NI 
outcomes, certain structured transactions involving amounts similar to 
interest, and imported mismatches.
3. Alternatives Considered
i. Addressing conduit arrangements/imported mismatches
    Section 267A(e)(1) provides regulatory authority to apply the rules 
of section 267A to conduit arrangements and thus to disallow a 
deduction in cases in which income attributable to a payment is 
directly or indirectly offset by an offshore hybrid deduction. The 
Treasury Department and the IRS considered four options with regards to 
conduit arrangement rules.
    The first option was to not implement any conduit rules, and thus 
rely on existing and established judicial doctrines (such as conduit 
principles and substance-over-form principles) to police these 
transactions. A second option considered was to address conduit 
arrangement concerns through a broad anti-abuse rule. On the one hand, 
both of these approaches might reduce complexity by eliminating the 
need for detailed regulatory rules addressing conduit arrangements. On 
the other hand, such approaches could create uncertainty (as neither 
taxpayers nor the IRS might have a clear sense of what types of 
transactions might be challenged under the judicial doctrines or anti-
abuse rule) and could increase burdens to the IRS (as challenging under 
judicial doctrines or anti-abuse rules are generally difficult and 
resource intensive). Significantly, such approaches could result in 
double non-taxation (if judicial doctrines or anti-abuse rules were to 
not be successfully asserted) or double-taxation (if judicial doctrines 
or anti-abuse rules were to not take into account the application of 
foreign tax law, such as a foreign imported mismatch rule).
    A third option considered was to implement rules modeled off 
existing U.S. anti-conduit rules under Sec.  1.881-3. On the positive 
side, such an approach would rely on an established and existing 
framework that taxpayers are already familiar with and thus there would 
be a lesser need to create and apply a new framework or set of rules. 
On the negative side, existing anti-conduit rules are limited in 
certain respects as they apply only to certain financing arrangements, 
which exclude certain stock, and they address only withholding tax 
policies, which pose separate concerns from section 267A policies (D/NI 
policies). Furthermore, taxpayers have implemented structures that 
attempt to avoid the application of the existing anti-conduit rules. 
Detrimental to tax equity, such an approach could also lead to double-
taxation, as the existing anti-conduit rules do not take into account 
the application of foreign tax law, such as a foreign imported mismatch 
rule.
    The final option considered was to implement rules that are 
generally consistent with the BEPS imported mismatch rule. The first 
advantage of such an approach is that it provides certainty about when 
a deduction will or will not be disallowed under the rule. The second 
advantage of this approach is that it neutralizes the risk of double 
non-taxation, while also neutralizing the risk of double taxation. This 
is because this option is modeled off the BEPS approach, which is being 
implemented by other countries, and also contains explicit rules to 
coordinate with foreign tax law. Coordinating with the global tax 
community reduces opportunities for economic distortions. Although such 
an approach involves greater complexity than the alternatives, the 
Treasury Department and IRS expect the benefits of this approach's 
comprehensiveness, administrability, and conduciveness to taxpayer 
certainty, to be substantially greater than the complexity burden in 
comparison with the available alternative approaches. Thus, this is the 
approach adopted in the proposed regulations.
ii. De Minimis Rules
    The proposed regulations provide a de minimis exception that 
exempts taxpayers from the application of section 267A for any taxable 
year for which the sum of the taxpayer's interest and royalty 
deductions (plus interest and royalty deductions of any related 
specified parties) is below $50,000. The exception's $50,000 threshold 
looks to a taxpayer's amount of interest or royalty deductions without 
regard to whether the deductions involve hybrid arrangements and 
therefore, absent the de minimis exception, would be disallowed under 
section 267A.
    The Treasury Department and the IRS considered not providing a de 
minimis exception because hybrid arrangements are highly likely to be 
tax-motivated structures undertaken only by mostly sophisticated 
investors. However, it is possible that, in limited cases, small 
taxpayers could be subject to these rules, for example, as a result of 
timing differences or a lack of familiarity with foreign law. 
Furthermore, section 267A is intended to stop base erosion and tax 
avoidance, and in the case of small taxpayers, it is expected that the 
revenue gains from applying these rules would be minimal since few 
small taxpayers are expected to engage in hybrid arrangements.
    The Treasury Department and IRS also considered a de minimis 
exception based on a dollar threshold with respect to the amount of 
interest or royalties involving hybrid arrangements. However, such an 
approach would require a taxpayer to first apply the rules of section 
267A to identify its interest or royalty deductions involving hybrid 
arrangements in order to

[[Page 67628]]

determine whether the de minimis threshold is satisfied and thus 
whether it is subject to section 267A for the taxable year. This would 
therefore not significantly reduce burdens on taxpayers with respect to 
applying the rules of section 267A.
    Therefore, the proposed regulations adopt a rule that looks to the 
overall amount of interest and royalty payments, whether or not such 
payments involve hybrid arrangements. This has the effect of exempting, 
in an efficient manner, small taxpayers that are unlikely to engage in 
hybrid arrangements, and therefore such taxpayers do not need to 
consider the application of these rules.
iii. Deemed Branch Payments and Branch Mismatch Payments
    The proposed regulations expand the application of section 267A to 
certain transactions involving branches. This was necessary in order to 
ensure that taxpayers could not avoid section 267A by engaging in 
transactions that were economically similar to the hybrid arrangements 
that are covered by the statute. For example, assume that a related 
party payment is made to a foreign entity in Country X that is owned by 
a parent company in Country Y. Further assume that there is a mismatch 
between how Country X views the entity (fiscally transparent) versus 
how Country Y views it (not fiscally transparent). In general, section 
267A's hybrid entity rules prevent a D/NI outcome in this case. 
However, assume instead that the parent company forms a branch in 
Country X instead of a foreign entity, and Country Y (the parent 
company's jurisdiction) exempts all branch income under its territorial 
system. On the other hand, due to a mismatch in laws governing whether 
a branch exists, Country X does not view the branch as existing and 
therefore does not tax payments made to the branch. Absent regulations, 
taxpayers could easily avoid section 267A through use of branch 
structures, which are economically similar to the foreign entity 
structure in the first example.
    In the absence of the proposed regulations, taxpayers may have 
found it valuable to engage in transactions that are economically 
similar to hybrid arrangements but that avoided the application of 
267A. Such transactions would have resulted in a loss in U.S. tax 
revenue without any accompanying efficiency gain. Furthermore, to the 
extent that these transactions were structured specifically to avoid 
the application of section 267A and were not available to all 
taxpayers, they would generally have led to an efficiency loss in 
addition to the loss in U.S. tax revenue.
iv. Exceptions for Income Included in U.S. Tax and GILTI Inclusions
    Section 267A(b)(1) provides that deductions for interest and 
royalties that are paid to a CFC and included under section 951(a) in 
income (as subpart F income) by a United States shareholder of such CFC 
are not subject to disallowance under section 267A. The statute does 
not state whether section 267A applies to a payment that is included 
directly in the U.S. tax base (for example, because the payment is made 
directly to a U.S. taxpayer or a U.S. taxable branch), or a payment 
made to a CFC that is taken into account under GILTI (as opposed to 
being included as subpart F income) by such CFC's United States 
shareholders. However, the grant of regulatory authority in section 
267A(e) includes a specific mention of exceptions in ``cases which the 
Secretary determines do not present a risk of eroding the Federal tax 
base.'' See section 267A(e)(7)(B).
    The Treasury Department and the IRS considered providing no 
additional exception for payments included in the U.S. tax base (either 
directly or under GILTI), therefore the only exception available would 
be the exception provided in the statute for payments included in the 
U.S tax base by subpart F inclusions. This approach was rejected in the 
case of a payment to a U.S. taxpayer since it would result in double 
taxation by the United States, as the United States would both deny a 
deduction for a payment as well as fully include such payment in income 
for U.S. tax purposes. Similarly, in the case of hybrid payments made 
by one CFC to another CFC with the same United States shareholders, a 
payment would be included in tested income of the recipient CFC and 
therefore taken into account under GILTI. If section 267A were to apply 
to also disallow the deduction by the payor CFC, this could also lead 
to the same amount being subject to section 951A twice because the 
payor CFC's tested income would increase as a result of the denial of 
deduction, and the payee would have additional tested income for the 
same payment.
    Payments that are included directly in the U.S. tax base or that 
are included in GILTI do not give rise to a D/NI outcome and, 
therefore, it is consistent with the policy of section 267A and the 
grant of authority in section 267A(e) to exempt them from disallowance 
under section 267A. Therefore, the proposed regulations provide that 
such payments are not subject to disallowance under section 267A.
v. Link Between Hybridity and D/NI
    As discussed in section II.E of the Explanation of Provisions and 
section I.D.2.ii of this Special Analyses, the proposed regulations 
limit disallowance to cases in which the no-inclusion portion of the D/
NI outcome is a result of hybridity as opposed to a different feature 
of foreign tax law, such as a general preference for royalty income.
    Under the language of the statute, no link between hybridity and 
the no-inclusion outcome appears to be required. The Treasury 
Department and the IRS considered following this approach, which would 
have resulted in a deduction being disallowed even though if the 
transaction had been a non-hybrid transaction, the same no-inclusion 
outcome would have resulted. However, the Treasury Department and the 
IRS rejected this option because it would lead to inconsistent and 
arbitrary results. In particular, such an approach would incentivize 
taxpayers to restructure to eliminate hybridity in order to avoid the 
application of section 267A in cases where hybridity does not cause a 
D/NI outcome. Such restructuring would eliminate the hybridity without 
actually eliminating the D/NI outcome since the hybridity did not cause 
the D/NI outcome. Interpreting section 267A in a manner that 
incentivizes taxpayers to engage in restructurings of this type would 
generally impose costs on taxpayers to retain deductions where 
hybridity is irrelevant to a D/NI outcome, without furthering the 
statutory purpose of section 267A to neutralize hybrid arrangements.
    Furthermore, the policy of section 267A is not to address all 
situations that give rise to no-inclusion outcomes, but to only address 
a subset of such situations where they arise due to hybrid 
arrangements. When base erosion or double non-taxation arises due to 
other features of the international tax system (such as the existence 
of low-tax jurisdictions or preferential regimes for certain types of 
income), there are other types of rules that are better suited to 
address these concerns (for example, through statutory impositions of 
withholding taxes, revisions to tax treaties, or new statutory 
provisions such as the base erosion and anti-abuse tax under section 
59A). Moreover, the legislative history to section 267A makes clear 
that the policy of the provision is to eliminate the tax-motivated 
hybrid structures that lead to D/NI outcomes, and was not a general 
provision for eliminating all cases of D/

[[Page 67629]]

NI outcomes. See Senate Explanation, at 384 (``[T]he Committee believes 
that hybrid arrangements exploit differences in the tax treatment of a 
transaction or entity under the laws of two or more jurisdictions to 
achieve double non-taxation . . .'') (emphasis added). In addition, to 
the extent that regulations limit disallowance to those cases in which 
the no-inclusion portion of the D/NI outcome is a result of hybridity, 
the scope of section 267A is limited and the burden on taxpayers is 
reduced without impacting the core policy underlying section 267A. 
Therefore, the proposed regulations provide that a deduction is 
disallowed under section 267A only to the extent that the no-inclusion 
portion of the D/NI outcome is a result of hybridity.
vi. Timing Differences Under Section 245A
    In some cases, there may be a timing difference between when a CFC 
pays an amount constituting a dividend for U.S. tax purposes and when 
the CFC receives a deduction for the amount in a foreign jurisdiction. 
Timing differences may raise issues about whether a deduction is a 
hybrid deduction and thus whether a dividend is considered a hybrid 
dividend. The Treasury Department and the IRS considered three options 
with respect to this timing issue.
    The first option considered was to not address timing differences, 
and thus not treat such transactions as giving rise to hybrid 
dividends. Not addressing the timing differences would raise policy 
concerns, since failure to treat the deduction as giving rise to a 
hybrid dividend would result in the section 245A(a) DRD applying to the 
dividend, allowing the amount to permanently escape both foreign tax 
(through the deduction) and U.S. tax (through the DRD).
    The second option considered was to not address the timing 
difference directly under section 245A(e), but instead address it under 
another Code section or regime. For example, one method that would be 
consistent with the BEPS Report would be to mandate an income inclusion 
to the U.S. parent corporation at the time the deduction is permitted 
under foreign law. This would rely on a novel approach that deems an 
inclusion at a particular point in time despite the fact that the 
income has otherwise not been recognized for U.S. tax purposes.
    The final option was to address the timing difference by providing 
rules requiring the establishment of hybrid deduction accounts. These 
hybrid deduction accounts will be maintained across years so that 
deductions that accrue in one year will be matched up with income 
arising in a different year, thus addressing the timing differences 
issue. This approach appropriately addresses the timing differences 
under section 245A of the Code. The Treasury Department and IRS expect 
the benefits of this option's comprehensiveness and clarity to be 
substantially greater than the tax administration and compliance costs 
it imposes, relative to the alternative options. This is the approach 
adopted by the proposed regulations.
vii. Timing Differences Under Section 267A
    A similar timing issue arises under section 267A. Here, there is a 
timing difference between when the deduction is otherwise permitted 
under U.S. tax law and when the payment is included in the payee's 
income under foreign tax law. The legislative history to section 267A 
indicates that in certain cases such timing differences can lead to 
``long term deferral'' and that such long-term deferral should be 
treated as giving rise to a D/NI outcome. In the context of section 
267A, the Treasury Department and the IRS considered three options with 
respect to this timing issue.
    The first option considered was to not address timing differences, 
because they will eventually reverse over time. Although such an 
approach would result in a relatively simple rule, it would raise 
significant policy concerns because, as indicated in the legislative 
history, long-term deferral can be equivalent to a permanent exclusion.
    The second option considered was to address all timing differences, 
because even a timing difference that reverses within a short period of 
time provides a tax benefit during the short term. Although such an 
approach might be conceptually pure, it would raise significant 
practical and administrative difficulties. It could also lead to some 
double-tax, absent complicated rules to calibrate the disallowed amount 
to the amount of tax benefit arising from the timing mismatch.
    The final option considered was to address only certain timing 
differences--namely, long-term timing differences, such as timing 
differences that do not reverse within a 3 taxable year period. The 
Treasury Department and IRS expect that the net benefits of this 
option's comprehensiveness, clarity, and tax administrability and 
compliance burden are substantially higher than those of the available 
alternatives. Thus, this option is adopted in the proposed regulations.
4. Anticipated Impacts on Administrative and Compliance Costs
    The Treasury Department and the IRS estimate that there are 
approximately 10,000 taxpayers in the current population of taxpayers 
affected by the proposed regulations or about 0.5% of all corporate 
filers. This is the best estimate of the number of sophisticated 
taxpayers with capabilities to structure a hybrid arrangement. However, 
the Treasury Department and the IRS anticipate that fewer taxpayers 
would engage in hybrid arrangements going forward as the statute and 
the proposed regulations would make such arrangements less beneficial 
to taxpayers. As such, the taxpayer counts provided in section II of 
this Special Analyses are an upper bound of the number of affected 
taxpayers by the proposed regulations.
    It is important to note that the population of taxpayers affected 
by section 267A and the proposed regulations under section 267A will 
seldom include U.S.-based companies as these companies are taxed under 
the new GILTI regime as well as subpart F. Instead, section 267A and 
the proposed regulations apply predominantly to foreign-headquartered 
companies that employ hybrid arrangements to strip income out of the 
U.S., undermining the collection of U.S. tax revenue. In addition, 
although section 245A(e) applies primarily to U.S.-based companies, the 
amounts of dividends affected are limited because a large portion of 
distributions will be treated as previously taxed earnings and profits 
due to the operation of both the GILTI regime and the transition tax 
under section 965, and such distributions are not subject to section 
245A(e).

II. Paperwork Reduction Act

    The collections of information in the proposed regulations are in 
proposed Sec. Sec.  1.6038-2(f)(13) and (14), 1.6038-3(g)(3), and 
1.6038A-2(b)(5)(iii).
    The collection of information in proposed Sec.  1.6038-2(f)(13) and 
(14) is mandatory for every U.S. person that controls a foreign 
corporation that has a deduction disallowed under section 267A, or that 
pays or receives a hybrid dividend or tiered hybrid dividend under 
section 245A, respectively, during an annual accounting period and 
files Form 5471 for that period (OMB control number 1545-0123, 
formerly, OMB control number 1545-0704). The collection of information 
in proposed Sec.  1.6038-2(f)(13) is satisfied by providing information 
about the disallowance of the deduction for any interest or royalty 
under section 267A

[[Page 67630]]

for the corporation's accounting period as Form 5471 and its 
instructions may prescribe, and the collection of information in 
proposed Sec.  1.6038-2(f)(14) is satisfied by providing information 
about hybrid dividends or tiered hybrid dividends under section 245A(e) 
for the corporation's accounting period as Form 5471 and its 
instructions may prescribe. For purposes of the PRA, the reporting 
burden associated with proposed Sec.  1.6038-2(f)(13) and (14) will be 
reflected in the IRS Form 14029, Paperwork Reduction Act Submission, 
associated with Form 5471. As provided below, the estimated number of 
respondents for the reporting burden associated with proposed Sec.  
1.6038-2(f)(13) and (14) is 1,000 and 2,000, respectively.
    The collection of information in proposed Sec.  1.6038-3(g)(3) is 
mandatory for every U.S. person that controls a foreign partnership 
that paid or accrued any interest or royalty for which a deduction is 
disallowed under section 267A during the partnership tax year and files 
Form 8865 for that period (OMB control number 1545-1668). The 
collection of information in proposed Sec.  1.6038-3(g)(3) is satisfied 
by providing information about the disallowance of the deduction for 
any interest or royalty under section 267A for the partnership's tax 
year as Form 8865 and its instructions may prescribe. For purposes of 
the PRA, the reporting burden associated with proposed Sec.  1.6038-
3(g)(3) will be reflected in the IRS Form 14029, Paperwork Reduction 
Act submission, associated with Form 8865. As provided below, the 
estimated number of respondents for the reporting burden associated 
with proposed Sec.  1.6038-3(g)(3) is less than 1,000.
    The collection of information in proposed Sec.  1.6038A-
2(b)(5)(iii) is mandatory for every reporting corporation that has a 
deduction disallowed under section 267A and files Form 5472 (OMB 
control number 1545-0123, formerly, OMB control number 1545-0805) for 
the tax year. The collection of information in proposed Sec.  1.6038A-
2(b)(5)(iii) is satisfied by providing information about the 
disallowance of the reporting corporation's deduction for any interest 
or royalty under section 267A for the tax year as Form 5472 and its 
instructions may prescribe. For purposes of the PRA, the reporting 
burden associated with proposed Sec.  1.6038A-2(b)(5)(iii) will be 
reflected in the IRS Form 14029, Paperwork Reduction Act submission, 
associated with Form 5472. As provided below, the estimated number of 
respondents for the reporting burden associated with proposed Sec.  
1.6038A-2(b)(5)(iii) is 7,000.
    The revised tax forms are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   Number of
                                                                                                  respondents
                                                                 New           Revision of        (estimated,
                                                                              existing form        rounded to
                                                                                                 nearest 1,000)
----------------------------------------------------------------------------------------------------------------
Schedule G (Form 5471)...................................  ..............            [check]               1,000
Schedule I (Form 5471)...................................  ..............            [check]               2,000
Form 5472................................................  ..............            [check]               7,000
Form 8865................................................  ..............            [check]              <1,000
----------------------------------------------------------------------------------------------------------------

    The current status of the Paperwork Reduction Act submissions 
related to the tax forms that will be revised as a result of the 
information collections in the proposed regulations is provided in the 
accompanying table. As described above, the reporting burdens 
associated with the information collections in proposed Sec. Sec.  
1.6038-2(f)(13) and (14) and 1.6038A-2(b)(5)(iii) are included in the 
aggregated burden estimates for OMB control number 1545-0123, which 
represents a total estimated burden time for all forms and schedules 
for corporations of 3.157 billion hours and total estimated monetized 
costs of $58.148 billion ($2017). The overall burden estimates provided 
in 1545-0123 are aggregate amounts that relate to the entire package of 
forms associated with the OMB control number and will in the future 
include but not isolate the estimated burden of the tax forms that will 
be revised as a result of the information collections in the proposed 
regulations. These numbers are therefore unrelated to the future 
calculations needed to assess the burden imposed by the proposed 
regulations. They are further identical to numbers provided for the 
proposed regulations relating to foreign tax credits (83 FR 63200). The 
Treasury Department and IRS urge readers to recognize that these 
numbers are duplicates and to guard against overcounting the burden 
that international tax provisions imposed prior to the Act. No burden 
estimates specific to the proposed regulations are currently available. 
The Treasury Department has not identified any burden estimates, 
including those for new information collections, related to the 
requirements under the proposed regulations. Those estimates would 
capture both changes made by the Act and those that arise out of 
discretionary authority exercised in the proposed regulations. The 
Treasury Department and the IRS request comments on all aspects of 
information collection burdens related to the proposed regulations. In 
addition, when available, drafts of IRS forms are posted for comment at 
https://apps.irs.gov/app/picklist/list/draftTaxForms.htm.

----------------------------------------------------------------------------------------------------------------
                 Form                       Type of filer               OMB No.                   Status
----------------------------------------------------------------------------------------------------------------
Form 5471............................  All other Filers         1545-0121..............  Approved by OMB through
                                        (mainly trusts and                                10/30/2020.
                                        estates) (Legacy
                                        system).
                                      --------------------------------------------------------------------------
                                       Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201704-1545-023 023.
                                      --------------------------------------------------------------------------
                                       Business (NEW Model)...  1545-0123..............  Published in the
                                                                                          Federal Register
                                                                                          Notice (FRN) on 10/8/
                                                                                          18. Public Comment
                                                                                          period closed on 12/10/
                                                                                          18.
                                      --------------------------------------------------------------------------
                                       Link: https://www.federalregister.gov/documents/2018/10/09/2018-21846/proposed-collection-comment-request-for-forms-1065-1065-b-1066-1120-1120-c-1120-f-1120-h-1120-nd.
                                      --------------------------------------------------------------------------

[[Page 67631]]

 
                                       Individual (NEW Model).  1545-0074..............  Limited Scope
                                                                                          submission (1040 only)
                                                                                          on 10/11/18 at OIRA
                                                                                          for review. Full ICR
                                                                                          submission (all forms)
                                                                                          scheduled in 3/2019.
                                                                                         60 Day FRN not
                                                                                          published yet for full
                                                                                          collection.
                                      --------------------------------------------------------------------------
                                       Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201808-1545-031 031.
                                      --------------------------------------------------------------------------
Form 5472............................  Business (NEW Model)...  1545-0123..............  Published in the FRN on
                                                                                          10/8/18. Public
                                                                                          Comment period closed
                                                                                          on 12/10/18.
                                      --------------------------------------------------------------------------
                                       Link: https://www.federalregister.gov/documents/2018/10/09/2018-21846/proposed-collection-comment-request-for-forms-1065-1065-b-1066-1120-1120-c-1120-f-1120-h-1120-nd.
                                      --------------------------------------------------------------------------
                                       Individual (NEW Model).  1545-0074..............  Limited Scope
                                                                                          submission (1040 only)
                                                                                          on 10/11/18 at OIRA
                                                                                          for review. Full ICR
                                                                                          submission for all
                                                                                          forms in 3/2019. 60
                                                                                          Day FRN not published
                                                                                          yet for full
                                                                                          collection.
                                      --------------------------------------------------------------------------
                                       Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201808-1545-031 031.
----------------------------------------------------------------------------------------------------------------
Form 8865............................  All other Filers         1545-1668..............  Published in the FRN on
                                        (mainly trusts and                                10/1/18. Public
                                        estates) (Legacy                                  Comment period closed
                                        system).                                          on 11/30/18. ICR in
                                                                                          process by Treasury as
                                                                                          of 10/17/18.
                                      --------------------------------------------------------------------------
                                       Link: https://www.federalregister.gov/documents/2018/10/01/2018-21288/proposed-collection-comment-request-for-regulation-project.
                                      --------------------------------------------------------------------------
                                       Business (NEW Model)...  1545-0123..............  Published in the FRN on
                                                                                          10/8/18. Public
                                                                                          Comment period closed
                                                                                          on 12/10/18.
                                      --------------------------------------------------------------------------
                                       Link: https://www.federalregister.gov/documents/2018/10/09/2018-21846/proposed-collection-comment-request-for-forms-1065-1065-b-1066-1120-1120-c-1120-f-1120-h-1120-nd.
                                      --------------------------------------------------------------------------
                                       Individual (NEW Model).  1545-0074..............  Limited Scope
                                                                                          submission (1040 only)
                                                                                          on 10/11/18 at OIRA
                                                                                          for review. Full ICR
                                                                                          submission for all
                                                                                          forms in 3/2019. 60
                                                                                          Day FRN not published
                                                                                          yet for full
                                                                                          collection.
                                      --------------------------------------------------------------------------
                                       Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201808-1545-031 031.
----------------------------------------------------------------------------------------------------------------

III. Regulatory Flexibility Act

    It is hereby certified that this notice of proposed rulemaking will 
not have a significant economic impact on a substantial number of small 
entities within the meaning of section 601(6) of the Regulatory 
Flexibility Act (5 U.S.C. chapter 6).
    The small entities that are subject to proposed Sec. Sec.  1.6038-
2(f)(13), 1.6038-3(g)(3), and 1.6038A-2(b)(5)(iii) are small entities 
that are controlling U.S. shareholders of a CFC that is disallowed a 
deduction under section 267A, small entities that are controlling 
fifty-percent partners of a foreign partnership that makes a payment 
for which a deduction is disallowed under section 267A, and small 
entities that are 25 percent foreign-owned domestic corporations and 
disallowed a deduction under section 267A, respectively. In addition, 
the small entities that are subject to proposed Sec.  1.6038-2(f)(14) 
are controlling U.S. shareholders of a CFC that pays or received a 
hybrid dividend or a tiered hybrid dividend.
    A controlling U.S. shareholder of a CFC is a U.S. person that owns 
more than 50 percent of the CFC's stock. A controlling fifty-percent 
partner is a U.S. person that owns more than a fifty-percent interest 
in the foreign partnership. A 25 percent foreign-owned domestic 
corporation is a domestic corporation at least 25 percent of the stock 
of which is owned by a foreign person.
    The Treasury Department and the IRS do not have data readily 
available to assess the number of small entities potentially affected 
by proposed Sec. Sec.  1.6038-2(f)(13) or (14), 1.6038-3(g)(3), or 
1.6038A-2(b)(5)(iii). However, entities potentially affected by these 
sections are generally not small businesses, because the resources and 
investment necessary for an entity to be a controlling U.S. 
shareholder, a controlling fifty-percent partner, or a 25 percent 
foreign-owned domestic corporation are generally significant. Moreover, 
the de minimis exception under section 267A excepts many small entities 
from the application of section 267A for any taxable year for which the 
sum of its interest and royalty deductions (plus interest and royalty 
deductions of certain related persons) is below $50,000. Therefore, the 
Treasury Department and the IRS do not believe that a substantial 
number of domestic small business entities will be subject to proposed 
Sec. Sec.  1.6038-2(f)(13) or (14), 1.6038-3(g)(3), or 1.6038A-
2(b)(5)(iii). Accordingly, the Treasury Department and the IRS do not 
believe that proposed Sec. Sec.  1.6038-2(f)(13) or (14), 1.6038-
3(g)(3), or 1.6038A-2(b)(5)(iii) will have a significant economic 
impact on a substantial number of small entities. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act is 
not required.
    The Treasury Department and the IRS do not believe that the 
proposed regulations have a significant economic impact on domestic 
small business entities. Based on published information from 2012 from 
form 5472, interest and royalty amounts paid to related foreign 
entities by foreign-owned

[[Page 67632]]

U.S. corporations over total receipts is 1.6 percent (https://www.irs.gov/statistics/soi-tax-stats-transactions-of-foreign-owned-domestic-corporations#_2, Classified by Industry 2012). This is 
substantially less than the 3 to 5 percent threshold for significant 
economic impact. The calculated percentage is likely to be an upper 
bound of the related party payments affected by the proposed hybrid 
regulations. In particular, this is the ratio of the potential income 
affected and not the tax revenues, which would be less than half this 
amount. While 1.6 percent is only for foreign-owned domestic 
corporations with total receipts of $500 million or more, these are 
entities that are more likely to have related party payments and so the 
percentage would be higher. Moreover, hybrid arrangements are only a 
subset of these related party payments; therefore this percentage is 
higher than what it would be if only considering hybrid arrangements.
    Notwithstanding this certification, Treasury and IRS invite 
comments about the impact this proposal may have on small entities.
    Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Requests for a Public Hearing

    Before the proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ADDRESSES heading. 
The Treasury Department and the IRS request comments on all aspects of 
the proposed rules. All comments will be available at 
www.regulations.gov or upon request. A public hearing will be scheduled 
if requested in writing by any person that timely submits written 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the public hearing will be published in the Federal 
Register.

Drafting Information

    The principal authors of the proposed regulations are Shane M. 
McCarrick and Tracy M. Villecco of the Office of Associate Chief 
Counsel (International). However, other personnel from the Treasury 
Department and the IRS participated in the development of the proposed 
regulations.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
sectional authorities for Sec. Sec.  1.245A(e)-1 and 1.267A-1 through 
1.267A-7 in numerical order and revising the entry for Sec.  1.6038A-2 
to read in part as follows:

    Authority:  26 U.S.C. 7805 * * *

    Section 1.245A(e)-1 also issued under 26 U.S.C. 245A(g).
* * * * *
    Sections 1.267A-1 through 1.267A-7 also issued under 26 U.S.C. 
267A(e).
* * * * *
    Section 1.6038A-2 also issued under 26 U.S.C. 6038A and 6038C.
* * * * *
0
Par. 2. Section 1.245A(e)-1 is added to read as follows:


Sec.  1.245A(e)-1   Special rules for hybrid dividends.

    (a) Overview. This section provides rules for hybrid dividends. 
Paragraph (b) of this section disallows the deduction under section 
245A(a) for a hybrid dividend received by a United States shareholder 
from a CFC. Paragraph (c) of this section provides a rule for hybrid 
dividends of tiered corporations. Paragraph (d) of this section sets 
forth rules regarding a hybrid deduction account. Paragraph (e) of this 
section provides an anti-avoidance rule. Paragraph (f) of this section 
provides definitions. Paragraph (g) of this section illustrates the 
application of the rules of this section through examples. Paragraph 
(h) of this section provides the applicability date.
    (b) Hybrid dividends received by United States shareholders--(1) In 
general. If a United States shareholder receives a hybrid dividend, 
then--
    (i) The United States shareholder is not allowed a deduction under 
section 245A(a) for the hybrid dividend; and
    (ii) The rules of section 245A(d) (disallowance of foreign tax 
credits and deductions) apply to the hybrid dividend.
    (2) Definition of hybrid dividend. The term hybrid dividend means 
an amount received by a United States shareholder from a CFC for which 
but for section 245A(e) and this section the United States shareholder 
would be allowed a deduction under section 245A(a), to the extent of 
the sum of the United States shareholder's hybrid deduction accounts 
(as described in paragraph (d) of this section) with respect to each 
share of stock of the CFC, determined at the close of the CFC's taxable 
year (or in accordance with paragraph (d)(5) of this section, as 
applicable). No other amount received by a United States shareholder 
from a CFC is a hybrid dividend for purposes of section 245A.
    (3) Special rule for certain dividends attributable to earnings of 
lower-tier foreign corporations. This paragraph (b)(3) applies if a 
domestic corporation sells or exchanges stock of a foreign corporation 
and, pursuant to section 1248, the gain recognized on the sale or 
exchange is included in gross income as a dividend. In such a case, for 
purposes of this section--
    (i) To the extent that earnings and profits of a lower-tier CFC 
gave rise to the dividend under section 1248(c)(2), those earnings and 
profits are treated as distributed as a dividend by the lower-tier CFC 
directly to the domestic corporation under the principles of Sec.  
1.1248-1(d); and
    (ii) To the extent the domestic corporation indirectly owns (within 
the meaning of section 958(a)(2)) shares of stock of the lower-tier 
CFC, the hybrid deduction accounts with respect to those shares are 
treated as hybrid deduction accounts of the domestic corporation. Thus, 
for example, if a domestic corporation sells or exchanges all the stock 
of an upper-tier CFC and under this paragraph (b)(3) there is 
considered to be a dividend paid directly by the lower-tier CFC to the 
domestic corporation, then the dividend is generally a hybrid dividend 
to the extent of the sum of the upper-tier CFC's hybrid deduction 
accounts with respect to stock of the lower-tier CFC.
    (4) Ordering rule. Amounts received by a United States shareholder 
from a CFC are subject to the rules of section 245A(e) and this section 
based on the order in which they are received. Thus, for example, if on 
different days during a CFC's taxable year a United States shareholder 
receives dividends from the CFC, then the rules of section 245A(e) and 
this section apply first to the dividend received on the earliest date 
(based on the sum of the United States shareholder's hybrid deduction 
accounts with respect to each share of stock of the CFC), and then to 
the

[[Page 67633]]

dividend received on the next earliest date (based on the remaining 
sum).
    (c) Hybrid dividends of tiered corporations--(1) In general. If a 
CFC (the receiving CFC) receives a tiered hybrid dividend from another 
CFC, and a domestic corporation is a United States shareholder with 
respect to both CFCs, then, notwithstanding any other provision of the 
Code--
    (i) The tiered hybrid dividend is treated for purposes of section 
951(a)(1)(A) as subpart F income of the receiving CFC for the taxable 
year of the CFC in which the tiered hybrid dividend is received;
    (ii) The United States shareholder must include in gross income an 
amount equal to its pro rata share (determined in the same manner as 
under section 951(a)(2)) of the subpart F income described in paragraph 
(c)(1)(i) of this section; and
    (iii) The rules of section 245A(d) (disallowance of foreign tax 
credit, including for taxes that would have been deemed paid under 
section 960(a) or (b), and deductions) apply to the amount included 
under paragraph (c)(1)(ii) of this section in the United States 
shareholder's gross income.
    (2) Definition of tiered hybrid dividend. The term tiered hybrid 
dividend means an amount received by a receiving CFC from another CFC 
to the extent that the amount would be a hybrid dividend under 
paragraph (b)(2) of this section if, for purposes of section 245A and 
the regulations under section 245A as contained in 26 CFR part 1 
(except for section 245A(e)(2) and this paragraph (c)), the receiving 
CFC were a domestic corporation. A tiered hybrid dividend does not 
include an amount described in section 959(b). No other amount received 
by a receiving CFC from another CFC is a tiered hybrid dividend for 
purposes of section 245A.
    (3) Special rule for certain dividends attributable to earnings of 
lower-tier foreign corporations. This paragraph (c)(3) applies if a CFC 
sells or exchanges stock of a foreign corporation and pursuant to 
section 964(e)(1) the gain recognized on the sale or exchange is 
included in gross income as a dividend. In such a case, rules similar 
to the rules of paragraph (b)(3) of this section apply.
    (4) Interaction with rules under section 964(e). To the extent a 
dividend described in section 964(e)(1) (gain on certain stock sales by 
CFCs treated as dividends) is a tiered hybrid dividend, the rules of 
section 964(e)(4) do not apply and, therefore, the United States 
shareholder is not allowed a deduction under section 245A(a) for the 
amount included in gross income under paragraph (c)(1)(ii) of this 
section.
    (d) Hybrid deduction accounts--(1) In general. A specified owner of 
a share of CFC stock must maintain a hybrid deduction account with 
respect to the share. The hybrid deduction account with respect to the 
share must reflect the amount of hybrid deductions of the CFC allocated 
to the share (as determined under paragraphs (d)(2) and (3) of this 
section), and must be maintained in accordance with the rules of 
paragraphs (d)(4) through (6) of this section.
    (2) Hybrid deductions--(i) In general. The term hybrid deduction of 
a CFC means a deduction or other tax benefit (such as an exemption, 
exclusion, or credit, to the extent equivalent to a deduction) for 
which the requirements of paragraphs (d)(2)(i)(A) and (B) of this 
section are both satisfied.
    (A) The deduction or other tax benefit is allowed to the CFC (or a 
person related to the CFC) under a relevant foreign tax law.
    (B) The deduction or other tax benefit relates to or results from 
an amount paid, accrued, or distributed with respect to an instrument 
issued by the CFC and treated as stock for U.S. tax purposes. Examples 
of such a deduction or other tax benefit include an interest deduction, 
a dividends paid deduction, and a deduction with respect to equity 
(such as a notional interest deduction). See paragraph (g)(1) of this 
section. However, a deduction or other tax benefit relating to or 
resulting from a distribution by the CFC with respect to an instrument 
treated as stock for purposes of the relevant foreign tax law is 
considered a hybrid deduction only to the extent it has the effect of 
causing the earnings that funded the distribution to not be included in 
income (determined under the principles of Sec.  1.267A-3(a)) or 
otherwise subject to tax under the CFC's tax law. Thus, for example, a 
refund to a shareholder of a CFC (including through a credit), upon a 
distribution by the CFC to the shareholder, of taxes paid by the CFC on 
the earnings that funded the distribution results in a hybrid deduction 
of the CFC, but only to the extent that the shareholder, if a tax 
resident of the CFC's country, does not include the distribution in 
income under the CFC's tax law or, if not a tax resident of the CFC's 
country, is not subject to withholding tax (as defined in section 
901(k)(1)(B)) on the distribution under the CFC's tax law. See 
paragraph (g)(2) of this section.
    (ii) Application limited to items allowed in taxable years 
beginning after December 31, 2017. A deduction or other tax benefit 
allowed to a CFC (or a person related to the CFC) under a relevant 
foreign tax law is taken into account for purposes of this section only 
if it was allowed with respect to a taxable year under the relevant 
foreign tax law beginning after December 31, 2017.
    (3) Allocating hybrid deductions to shares. A hybrid deduction is 
allocated to a share of stock of a CFC to the extent that the hybrid 
deduction (or amount equivalent to a deduction) relates to an amount 
paid, accrued, or distributed by the CFC with respect to the share. 
However, in the case of a hybrid deduction that is a deduction with 
respect to equity (such as a notional interest deduction), the 
deduction is allocated to a share of stock of a CFC based on the 
product of--
    (i) The amount of the deduction allowed for all of the equity of 
the CFC; and
    (ii) A fraction, the numerator of which is the value of the share 
and the denominator of which is the value of all of the stock of the 
CFC.
    (4) Maintenance of hybrid deduction accounts--(i) In general. A 
specified owner's hybrid deduction account with respect to a share of 
stock of a CFC is, as of the close of the taxable year of the CFC, 
adjusted pursuant to the following rules.
    (A) First, the account is increased by the amount of hybrid 
deductions of the CFC allocable to the share for the taxable year.
    (B) Second, the account is decreased by the amount of hybrid 
deductions in the account that gave rise to a hybrid dividend or tiered 
hybrid dividend during the taxable year. If a specified owner has more 
than one hybrid deduction account with respect to its stock of the CFC, 
then a pro rata amount in each hybrid deduction account is considered 
to have given rise to the hybrid dividend or tiered hybrid dividend, 
based on the amounts in the accounts before applying this paragraph 
(d)(4)(i)(B).
    (ii) Acquisition of account--(A) In general. The following rules 
apply when a person (the acquirer) acquires a share of stock of a CFC 
from another person (the transferor).
    (1) In the case of an acquirer that is a specified owner of the 
share immediately after the acquisition, the transferor's hybrid 
deduction account, if any, with respect to the share becomes the hybrid 
deduction account of the acquirer.
    (2) In the case of an acquirer that is not a specified owner of the 
share immediately after the acquisition, the transferor's hybrid 
deduction account, if any, is eliminated and accordingly is not 
thereafter taken into account by any person.

[[Page 67634]]

    (B) Additional rules. The following rules apply in addition to the 
rules of paragraph (d)(4)(ii)(A) of this section.
    (1) Certain section 354 or 356 exchanges. The following rules apply 
when a shareholder of a CFC (the CFC, the target CFC; the shareholder, 
the exchanging shareholder) exchanges stock of the target CFC for stock 
of another CFC (the acquiring CFC) pursuant to an exchange described in 
section 354 or 356 that occurs in connection with a transaction 
described in section 381(a)(2) in which the target CFC is the 
transferor corporation.
    (i) In the case of an exchanging shareholder that is a specified 
owner of one or more shares of stock of the acquiring CFC immediately 
after the exchange, the exchanging shareholder's hybrid deduction 
accounts with respect to the shares of stock of the target CFC that it 
exchanges are attributed to the shares of stock of the acquiring CFC 
that it receives in the exchange.
    (ii) In the case of an exchanging shareholder that is not a 
specified owner of one or more shares of stock of the acquiring CFC 
immediately after the exchange, the exchanging shareholder's hybrid 
deduction accounts with respect to its shares of stock of the target 
CFC are eliminated and accordingly are not thereafter taken into 
account by any person.
    (2) Section 332 liquidations. If a CFC is a distributor corporation 
in a transaction described in section 381(a)(1) (the distributing CFC) 
in which a controlled foreign corporation is the acquiring corporation 
(the distributee CFC), then each hybrid account with respect to a share 
of stock of the distributee CFC is increased pro rata by the sum of the 
hybrid accounts with respect to shares of stock of the distributing 
CFC.
    (3) Recapitalizations. If a shareholder of a CFC exchanges stock of 
the CFC pursuant to a reorganization described in section 368(a)(1)(E) 
or a transaction to which section 1036 applies, then the shareholder's 
hybrid deduction accounts with respect to the stock of the CFC that it 
exchanges are attributed to the shares of stock of the CFC that it 
receives in the exchange.
    (5) Determinations and adjustments made on transfer date in certain 
cases. This paragraph (d)(5) applies if on a date other than the date 
that is the last day of the CFC's taxable year a United States 
shareholder of the CFC or an upper-tier CFC with respect to the CFC 
directly or indirectly transfers a share of stock of the CFC, and, 
during the taxable year, but on or before the transfer date, the United 
States shareholder or upper-tier CFC receives an amount from the CFC 
that is subject to the rules of section 245A(e) and this section. In 
such a case, as to the United States shareholder or upper-tier CFC and 
the United States shareholder's or upper-tier CFC's hybrid deduction 
accounts with respect to each share of stock of the CFC (regardless of 
whether such share is transferred), the determinations and adjustments 
under this section that would otherwise be made at the close of the 
CFC's taxable year are made at the close of the date of the transfer. 
Thus, for example, if a United States shareholder of a CFC exchanges 
stock of the CFC in an exchange described in Sec.  1.367(b)-4(b)(1)(i) 
and is required to include in income as a deemed dividend the section 
1248 amount attributable to the stock exchanged, the sum of the United 
States shareholder's hybrid deduction accounts with respect to each 
share of stock of the CFC is determined, and the accounts are adjusted, 
as of the close of the date of the exchange. For this purpose, the 
principles of Sec.  1.1502-76(b)(2)(ii) apply to determine amounts in 
hybrid deduction accounts at the close of the date of the transfer.
    (6) Effects of CFC functional currency--(i) Maintenance of the 
hybrid deduction account. A hybrid deduction account with respect to a 
share of CFC stock must be maintained in the functional currency 
(within the meaning of section 985) of the CFC. Thus, for example, the 
amount of a hybrid deduction and the adjustments described in 
paragraphs (d)(4)(i)(A) and (B) of this section are determined based on 
the functional currency of the CFC. In addition, for purposes of this 
section, the amount of a deduction or other tax benefit allowed to a 
CFC (or a person related to the CFC) is determined taking into account 
foreign currency gain or loss recognized with respect to such deduction 
or other tax benefit under a provision of foreign tax law comparable to 
section 988 (treatment of certain foreign currency transactions).
    (ii) Determination of amount of hybrid dividend. This paragraph 
(d)(6)(ii) applies if a CFC's functional currency is other than the 
functional currency of a United States shareholder or upper-tier CFC 
that receives an amount from the CFC that is subject to the rules of 
section 245A(e) and this section. In such a case, the sum of the United 
States shareholder's or upper-tier CFC's hybrid deduction accounts with 
respect to each share of stock of the CFC is, for purposes of 
determining the extent that a dividend is a hybrid dividend or tiered 
hybrid dividend, translated into the functional currency of the United 
States shareholder or upper-tier CFC based on the spot rate (within the 
meaning of Sec.  1.988-1(d)) as of the date of the dividend.
    (e) Anti-avoidance rule. Appropriate adjustments are made pursuant 
to this section, including adjustments that would disregard the 
transaction or arrangement, if a transaction or arrangement is 
undertaken with a principal purpose of avoiding the purposes of this 
section. For example, if a specified owner of a share of CFC stock 
transfers the share to another person, and a principal purpose of the 
transfer is to shift the hybrid deduction account with respect to the 
share to the other person or to cause the hybrid deduction account to 
be eliminated, then for purposes of this section the shifting or 
elimination of the hybrid deduction account is disregarded as to the 
transferor. As another example, if a transaction or arrangement is 
undertaken to affirmatively fail to satisfy the holding period 
requirement under section 246(c)(5) with a principal purpose of 
avoiding the tiered hybrid dividend rules described in paragraph (c) of 
this section, the transaction or arrangement is disregarded for 
purposes of this section.
    (f) Definitions. The following definitions apply for purposes of 
this section.
    (1) The term controlled foreign corporation (or CFC) has the 
meaning provided in section 957.
    (2) The term person has the meaning provided in section 7701(a)(1).
    (3) The term related has the meaning provided in this paragraph 
(f)(3). A person is related to a CFC if the person is a related person 
within the meaning of section 954(d)(3).
    (4) The term relevant foreign tax law means, with respect to a CFC, 
any regime of any foreign country or possession of the United States 
that imposes an income, war profits, or excess profits tax with respect 
to income of the CFC, other than a foreign anti-deferral regime under 
which a person that owns an interest in the CFC is liable to tax. Thus, 
the term includes any regime of a foreign country or possession of the 
United States that imposes income, war profits, or excess profits tax 
under which--
    (i) The CFC is liable to tax as a resident;
    (ii) The CFC has a branch that gives rise to a taxable presence in 
the foreign country or possession of the United States; or
    (iii) A person related to the CFC is liable to tax as a resident, 
provided that under such person's tax law the person is allowed a 
deduction for amounts paid or accrued by the CFC (because, for

[[Page 67635]]

example, the CFC is fiscally transparent under the person's tax law).
    (5) The term specified owner means, with respect to a share of 
stock of a CFC, a person for which the requirements of paragraphs 
(f)(5)(i) and (ii) of this section are satisfied.
    (i) The person is a domestic corporation that is a United States 
shareholder of the CFC, or is an upper-tier CFC that would be a United 
States shareholder of the CFC were the upper-tier CFC a domestic 
corporation.
    (ii) The person owns the share directly or indirectly through a 
partnership, trust, or estate. Thus, for example, if a domestic 
corporation directly owns all the shares of stock of an upper-tier CFC 
and the upper-tier CFC directly owns all the shares of stock of another 
CFC, the domestic corporation is the specified owner with respect to 
each share of stock of the upper-tier CFC and the upper-tier CFC is the 
specified owner with respect to each share of stock of the other CFC.
    (6) The term United States shareholder has the meaning provided in 
section 951(b).
    (g) Examples. This paragraph (g) provides examples that illustrate 
the application of this section. For purposes of the examples in this 
paragraph (g), unless otherwise indicated, the following facts are 
presumed. US1 is a domestic corporation. FX and FZ are CFCs formed at 
the beginning of year 1. FX is a tax resident of Country X and FZ is a 
tax resident of Country Z. US1 is a United States shareholder with 
respect to FX and FZ. No distributed amounts are attributable to 
amounts which are, or have been, included in the gross income of a 
United States shareholder under section 951(a). All instruments are 
treated as stock for U.S. tax purposes.

    (1) Example 1. Hybrid dividend resulting from hybrid 
instrument--(i) Facts. US1 holds both shares of stock of FX, which 
have an equal value. One share is treated as indebtedness for 
Country X tax purposes (``Share A''), and the other is treated as 
equity for Country X tax purposes (``Share B''). During year 1, 
under Country X tax law, FX accrues $80x of interest to US1 with 
respect to Share A and is allowed a deduction for the amount (the 
``Hybrid Instrument Deduction''). During year 2, FX distributes $30x 
to US1 with respect to each of Share A and Share B. For U.S. tax 
purposes, each of the $30x distributions is treated as a dividend 
for which, but for section 245A(e) and this section, US1 would be 
allowed a deduction under section 245A(a). For Country X tax 
purposes, the $30x distribution with respect to Share A represents a 
payment of interest for which a deduction was already allowed (and 
thus FX is not allowed an additional deduction for the amount), and 
the $30x distribution with respect to Share B is treated as a 
dividend (for which no deduction is allowed).
    (ii) Analysis. The entire $30x of each dividend received by US1 
from FX during year 2 is a hybrid dividend, because the sum of US1's 
hybrid deduction accounts with respect to each of its shares of FX 
stock at the end of year 2 ($80x) is at least equal to the amount of 
the dividends ($60x). See paragraph (b)(2) of this section. This is 
the case for the $30x dividend with respect to Share B even though 
there are no hybrid deductions allocated to Share B. See id. As a 
result, US1 is not allowed a deduction under section 245A(a) for the 
entire $60x of hybrid dividends and the rules of section 245A(d) 
(disallowance of foreign tax credits and deductions) apply. See 
paragraph (b)(1) of this section. Paragraphs (g)(1)(ii)(A) through 
(D) of this section describe the determinations under this section.
    (A) At the end of year 1, US1's hybrid deduction accounts with 
respect to Share A and Share B are $80x and $0, respectively, 
calculated as follows.
    (1) The $80x Hybrid Instrument Deduction allowed to FX under 
Country X tax law (a relevant foreign tax law) is a hybrid deduction 
of FX, because the deduction is allowed to FX and relates to or 
results from an amount accrued with respect to an instrument issued 
by FX and treated as stock for U.S. tax purposes. See paragraph 
(d)(2)(i) of this section. Thus, FX's hybrid deductions for year 1 
are $80x.
    (2) The entire $80x Hybrid Instrument Deduction is allocated to 
Share A, because the deduction was accrued with respect to Share A. 
See paragraph (d)(3) of this section. As there are no additional 
hybrid deductions of FX for year 1, there are no additional hybrid 
deductions to allocate to either Share A or Share B. Thus, there are 
no hybrid deductions allocated to Share B.
    (3) At the end of year 1, US1's hybrid deduction account with 
respect to Share A is increased by $80x (the amount of hybrid 
deductions allocated to Share A). See paragraph (d)(4)(i)(A) of this 
section. Because FX did not pay any dividends with respect to either 
Share A or Share B during year 1 (and therefore did not pay any 
hybrid dividends or tiered hybrid dividends), no further adjustments 
are made. See paragraph (d)(4)(i)(B) of this section. Therefore, at 
the end of year 1, US1's hybrid deduction accounts with respect to 
Share A and Share B are $80x and $0, respectively.
    (B) At the end of year 2, and before the adjustments described 
in paragraph (d)(4)(i)(B) of this section, US1's hybrid deduction 
accounts with respect to Share A and Share B remain $80x and $0, 
respectively. This is because there are no hybrid deductions of FX 
for year 2. See paragraph (d)(4)(i)(A) of this section.
    (C) Because at the end of year 2 (and before the adjustments 
described in paragraph (d)(4)(i)(B) of this section) the sum of 
US1's hybrid deduction accounts with respect to Share A and Share B 
($80x, calculated as $80x plus $0) is at least equal to the 
aggregate $60x of year 2 dividends, the entire $60x dividend is a 
hybrid dividend. See paragraph (b)(2) of this section.
    (D) At the end of year 2, US1's hybrid deduction account with 
respect to Share A is decreased by $60x, the amount of the hybrid 
deductions in the account that gave rise to a hybrid dividend or 
tiered hybrid dividend during year 2. See paragraph (d)(4)(i)(B) of 
this section. Because there are no hybrid deductions in the hybrid 
deduction account with respect to Share B, no adjustments with 
respect to that account are made under paragraph (d)(4)(i)(B) of 
this section. Therefore, at the end of year 2 and taking into 
account the adjustments under paragraph (d)(4)(i)(B) of this 
section, US1's hybrid deduction account with respect to Share A is 
$20x ($80x less $60x) and with respect to Share B is $0.
    (iii) Alternative facts--notional interest deductions. The facts 
are the same as in paragraph (g)(1)(i) of this section, except that 
for each of year 1 and year 2 FX is allowed $10x of notional 
interest deductions with respect to its equity, Share B, under 
Country X tax law (the ``NIDs''). In addition, during year 2, FX 
distributes $47.5x (rather than $30x) to US1 with respect to each of 
Share A and Share B. For U.S. tax purposes, each of the $47.5x 
distributions is treated as a dividend for which, but for section 
245A(e) and this section, US1 would be allowed a deduction under 
section 245A(a). For Country X tax purposes, the $47.5x distribution 
with respect to Share A represents a payment of interest for which a 
deduction was already allowed (and thus FX is not allowed an 
additional deduction for the amount), and the $47.5x distribution 
with respect to Share B is treated as a dividend (for which no 
deduction is allowed). The entire $47.5x of each dividend received 
by US1 from FX during year 2 is a hybrid dividend, because the sum 
of US1's hybrid deduction accounts with respect to each of its 
shares of FX stock at the end of year 2 ($80x plus $20x, or $100x) 
is at least equal to the amount of the dividends ($95x). See 
paragraph (b)(2) of this section. As a result, US1 is not allowed a 
deduction under section 245A(a) for the $95x hybrid dividend and the 
rules of section 245A(d) (disallowance of foreign tax credits and 
deductions) apply. See paragraph (b)(1) of this section. Paragraphs 
(g)(1)(iii)(A) through (D) of this section describe the 
determinations under this section.
    (A) The $10x of NIDs allowed to FX under Country X tax law in 
year 1 are hybrid deductions of FX for year 1. See paragraph 
(d)(2)(i) of this section. The $10x of NIDs is allocated equally to 
each of Share A and Share B, because the hybrid deduction is with 
respect to equity and the shares have an equal value. See paragraph 
(d)(3) of this section. Thus, $5x of the NIDs is allocated to each 
of Share A and Share B for year 1. For the reasons described in 
paragraph (g)(1)(ii)(A) of this section, the entire $80x Hybrid 
Instrument Deduction is allocated to Share A. Therefore, at the end 
of year 1, US1's hybrid deduction accounts with respect to Share A 
and Share B are $85x and $5x, respectively.
    (B) Similarly, the $10x of NIDs allowed to FX under Country X 
tax law in year 2 are hybrid deductions of FX for year 2, and $5x of 
the NIDs is allocated to each of Share A and Share B for year 2. See 
paragraphs (d)(2)(i) and (d)(3) of this section. Thus, at the

[[Page 67636]]

end of year 2 (and before the adjustments described in paragraph 
(d)(4)(i)(B) of this section), US1's hybrid deduction account with 
respect to Share A is $90x ($85x plus $5x) and with respect to Share 
B is $10x ($5x plus $5x). See paragraph (d)(4)(i) of this section.
    (C) Because at the end of year 2 (and before the adjustments 
described in paragraph (d)(4)(i)(B) of this section) the sum of 
US1's hybrid deduction accounts with respect to Share A and Share B 
($100x, calculated as $90x plus $10x) is at least equal to the 
aggregate $95x of year 2 dividends, the entire $95x of dividends are 
hybrid dividends. See paragraph (b)(2) of this section.
    (D) At the end of year 2, US1's hybrid deduction accounts with 
respect to Share A and Share B are decreased by the amount of hybrid 
deductions in the accounts that gave rise to a hybrid dividend or 
tiered hybrid dividend during year 2. See paragraph (d)(4)(i)(B) of 
this section. A total of $95x of hybrid deductions in the accounts 
gave rise to a hybrid dividend during year 2. For the hybrid 
deduction account with respect to Share A, $85.5x in the account is 
considered to have given rise to a hybrid deduction (calculated as 
$95x multiplied by $90x/$100x). See id. For the hybrid deduction 
account with respect to Share B, $9.5x in the account is considered 
to have given rise to a hybrid deduction (calculated as $95x 
multiplied by $10x/$100x). See id. Thus, following these 
adjustments, at the end of year 2, US1's hybrid deduction account 
with respect to Share A is $4.5x ($90x less $85.5x) and with respect 
to Share B is $0.5x ($10x less $9.5x).
    (iv) Alternative facts--deduction in branch country--(A) Facts. 
The facts are the same as in paragraph (g)(1)(i) of this section, 
except that for Country X tax purposes Share A is treated as equity 
(and thus the Hybrid Instrument Deduction does not exist and under 
Country X tax law FX is not allowed a deduction for the $30x 
distributed in year 2 with respect to Share A). However, FX has a 
branch in Country Z that gives rise to a taxable presence under 
Country Z tax law, and for Country Z tax purposes Share A is treated 
as indebtedness and Share B is treated as equity. Also, during year 
1, for Country Z tax purposes, FX accrues $80x of interest to US1 
with respect to Share A and is allowed an $80x interest deduction 
with respect to its Country Z branch income. Moreover, for Country Z 
tax purposes, the $30x distribution with respect to Share A in year 
2 represents a payment of interest for which a deduction was already 
allowed (and thus FX is not allowed an additional deduction for the 
amount), and the $30x distribution with respect to Share B in year 2 
is treated as a dividend (for which no deduction is allowed).
    (B) Analysis. The $80x interest deduction allowed to FX under 
Country Z tax law (a relevant foreign tax law) with respect to its 
Country Z branch income is a hybrid deduction of FX for year 1. See 
paragraphs (d)(2)(i) and (f)(4) of this section. For reasons similar 
to those discussed in paragraph (g)(1)(ii) of this section, at the 
end of year 2 (and before the adjustments described in paragraph 
(d)(4)(i)(B) of this section), US1's hybrid deduction accounts with 
respect to Share A and Share B are $80x and $0, respectively, and 
the sum of the accounts is $80x. Accordingly, the entire $60x of the 
year 2 dividend is a hybrid dividend. See paragraph (b)(2) of this 
section. Further, for the reasons described in paragraph 
(g)(1)(ii)(D) of this section, at the end of year 2 and taking into 
account the adjustments under paragraph (d)(4)(i)(B) of this 
section, US1's hybrid deduction account with respect to Share A is 
$20x ($80x less $60x) and with respect to Share B is $0.
    (2) Example 2. Tiered hybrid dividend rule; tax benefit 
equivalent to a deduction--(i) Facts. US1 holds all the stock of FX, 
and FX holds all 100 shares of stock of FZ (the ``FZ shares''), 
which have an equal value. The FZ shares are treated as equity for 
Country Z tax purposes. During year 2, FZ distributes $10x to FX 
with respect to each of the FZ shares, for a total of $1,000x. The 
$1,000x is treated as a dividend for U.S. and Country Z tax 
purposes, and is not deductible for Country Z tax purposes. If FX 
were a domestic corporation, then, but for section 245A(e) and this 
section, FX would be allowed a deduction under section 245A(a) for 
the $1,000x. Under Country Z tax law, 75% of the corporate income 
tax paid by a Country Z corporation with respect to a dividend 
distribution is refunded to the corporation's shareholders 
(regardless of where such shareholders are tax residents) upon a 
dividend distribution by the corporation. The corporate tax rate in 
Country Z is 20%. With respect to FZ's distributions, FX is allowed 
a refundable tax credit of $187.5x. The $187.5x refundable tax 
credit is calculated as $1,250x (the amount of pre-tax earnings that 
funded the distribution, determined as $1,000x (the amount of the 
distribution) divided by 0.8 (the percentage of pre-tax earnings 
that a Country Z corporation retains after paying Country Z 
corporate tax)) multiplied by 0.2 (the Country Z corporate tax rate) 
multiplied by 0.75 (the percentage of the Country Z tax credit). 
Under Country Z tax law, FX is not subject to Country Z withholding 
tax (or any other tax) with respect to the $1,000x dividend 
distribution.
    (ii) Analysis. $937.5x of the $1,000x of dividends received by 
FX from FZ during year 2 is a tiered hybrid dividend, because the 
sum of FX's hybrid deduction accounts with respect to each of its 
shares of FZ stock at the end of year 2 is $937.5x. See paragraphs 
(b)(2) and (c)(2) of this section. As a result, the $937.5x tiered 
hybrid dividend is treated for purposes of section 951(a)(1)(A) as 
subpart F income of FX and US1 must include in gross income its pro 
rata share of such subpart F income, which is $937.5x. See paragraph 
(c)(1) of this section. In addition, the rules of section 245A(d) 
(disallowance of foreign tax credits and deductions) apply with 
respect to US1's inclusion. Id. Paragraphs (g)(2)(ii)(A) through (C) 
of this section describe the determinations under this section. The 
characterization of the FZ stock for Country X tax purposes (or for 
purposes of any other foreign tax law) does not affect this 
analysis.
    (A) The $187.5x refundable tax credit allowed to FX under 
Country Z tax law (a relevant foreign tax law) is equivalent to a 
$937.5x deduction, calculated as $187.5x (the amount of the credit) 
divided by 0.2 (the Country Z corporate tax rate). The $937.5x is a 
hybrid deduction of FZ because it is allowed to FX (a person related 
to FZ), it relates to or results from amounts distributed with 
respect to instruments issued by FZ and treated as stock for U.S. 
tax purposes, and it has the effect of causing the earnings that 
funded the distributions to not be included in income under Country 
Z tax law. See paragraph (d)(2)(i) of this section. $9.375x of the 
hybrid deduction is allocated to each of the FZ shares, calculated 
as $937.5x (the amount of the hybrid deduction) multiplied by 1/100 
(the value of each FZ share relative to the value of all the FZ 
shares). See paragraph (d)(3) of this section. The result would be 
the same if FX were instead a tax resident of Country Z (and not 
Country X) and under Country Z tax law FX were to not include the 
$1,000x in income (because, for example, Country Z tax law provides 
Country Z resident corporations a 100% exclusion or dividends 
received deduction with respect to dividends received from a 
resident corporation). See paragraph (d)(2)(i) of this section.
    (B) Thus, at the end of year 2, and before the adjustments 
described in paragraph (d)(4)(i)(B) of this section, the sum of FX's 
hybrid deduction accounts with respect to each of its shares of FZ 
stock is $937.5x, calculated as $9.375x (the amount in each account) 
multiplied by 100 (the number of accounts). See paragraph (d)(4)(i) 
of this section. Accordingly, $937.5x of the $1,000x dividend 
received by FX from FZ during year 2 is a tiered hybrid dividend. 
See paragraphs (b)(2) and (c)(2) of this section.
    (C) Lastly, at the end of year 2, each of FX's hybrid deduction 
accounts with respect to its shares of FZ is decreased by the 
$9.375x in the account that gave rise to a hybrid dividend or tiered 
hybrid dividend during year 2. See paragraph (d)(4)(i)(B) of this 
section. Thus, following these adjustments, at the end of year 2, 
each of FX's hybrid deduction accounts with respect to its shares of 
FZ stock is $0, calculated as $9.375x (the amount in the account 
before the adjustments described in paragraph (d)(4)(i)(B) of this 
section) less $9.375x (the adjustment described in paragraph 
(d)(4)(i)(B) of this section with respect to the account).
    (iii) Alternative facts--imputation system that taxes 
shareholders. The facts are the same as in paragraph (g)(2)(i) of 
this section, except that under Country Z tax law the $1,000 
dividend to FX is subject to a 30% gross basis withholding tax, or 
$300x, and the $187.5x refundable tax credit is applied against and 
reduces the withholding tax to $112.5x. The $187.5x refundable tax 
credit provided to FX is not a hybrid deduction because FX was 
subject to Country Z withholding tax of $300x on the $1,000x 
dividend (such withholding tax being greater than the $187.5x 
credit). See paragraph (d)(2)(i) of this section.

    (h) Applicability date. This section applies to distributions made 
after December 31, 2017.
0
Par. 3. Sections 1.267A-1 through 1.267A-7 are added to read as 
follows:

[[Page 67637]]

Sec.  1.267A-1  Disallowance of certain interest and royalty 
deductions.

    (a) Scope. This section and Sec. Sec.  1.267A-2 through 1.267A-5 
provide rules regarding when a deduction for any interest or royalty 
paid or accrued is disallowed under section 267A. Section 1.267A-2 
describes hybrid and branch arrangements. Section 1.267A-3 provides 
rules for determining income inclusions and provides that certain 
amounts are not amounts for which a deduction is disallowed. Section 
1.267A-4 provides an imported mismatch rule. Section 1.267A-5 sets 
forth definitions and special rules that apply for purposes of section 
267A. Section 1.267A-6 illustrates the application of section 267A 
through examples. Section 1.267A-7 provides applicability dates.
    (b) Disallowance of deduction. This paragraph (b) sets forth the 
exclusive circumstances in which a deduction is disallowed under 
section 267A. Except as provided in paragraph (c) of this section, a 
specified party's deduction for any interest or royalty paid or accrued 
(the amount paid or accrued with respect to the specified party, a 
specified payment) is disallowed under section 267A to the extent that 
the specified payment is described in this paragraph (b). See also 
Sec.  1.267A-5(b)(5) (treating structured payments as specified 
payments). A specified payment is described in this paragraph (b) to 
the extent that it is--
    (1) A disqualified hybrid amount, as described in Sec.  1.267A-2 
(hybrid and branch arrangements);
    (2) A disqualified imported mismatch amount, as described in Sec.  
1.267A-4 (payments offset by a hybrid deduction); or
    (3) A specified payment for which the requirements of the anti-
avoidance rule of Sec.  1.267A-5(b)(6) are satisfied.
    (c) De minimis exception. Paragraph (b) of this section does not 
apply to a specified party for a taxable year in which the sum of the 
specified party's interest and royalty deductions (determined without 
regard to this section) is less than $50,000. For purposes of this 
paragraph (c), specified parties that are related (within the meaning 
of Sec.  1.267A-5(a)(14)) are treated as a single specified party.


Sec.  1.267A-2  Hybrid and branch arrangements.

    (a) Payments pursuant to hybrid transactions--(1) In general. If a 
specified payment is made pursuant to a hybrid transaction, then, 
subject to Sec.  1.267A-3(b) (amounts included or includible in 
income), the payment is a disqualified hybrid amount to the extent 
that--
    (i) A specified recipient of the payment does not include the 
payment in income, as determined under Sec.  1.267A-3(a) (to such 
extent, a no-inclusion); and
    (ii) The specified recipient's no-inclusion is a result of the 
payment being made pursuant to the hybrid transaction. For this 
purpose, the specified recipient's no-inclusion is a result of the 
specified payment being made pursuant to the hybrid transaction to the 
extent that the no-inclusion would not occur were the specified 
recipient's tax law to treat the payment as interest or a royalty, as 
applicable. See Sec.  1.267A-6(c)(1) and (2).
    (2) Definition of hybrid transaction. The term hybrid transaction 
means any transaction, series of transactions, agreement, or instrument 
one or more payments with respect to which are treated as interest or 
royalties for U.S. tax purposes but are not so treated for purposes of 
the tax law of a specified recipient of the payment. Examples of a 
hybrid transaction include an instrument a payment with respect to 
which is treated as interest for U.S. tax purposes but, for purposes of 
a specified recipient's tax law, is treated as a distribution with 
respect to equity or a return of principal. In addition, a specified 
payment is deemed to be made pursuant to a hybrid transaction if the 
taxable year in which a specified recipient recognizes the payment 
under its tax law ends more than 36 months after the end of the taxable 
year in which the specified party would be allowed a deduction for the 
payment under U.S. tax law. See also Sec.  1.267A-6(c)(8). Further, a 
specified payment is not considered made pursuant to a hybrid 
transaction if the payment is a disregarded payment, as described in 
paragraph (b)(2) of this section.
    (3) Payments pursuant to securities lending transactions, sale-
repurchase transactions, or similar transactions. This paragraph (a)(3) 
applies if a specified payment is made pursuant to a repo transaction 
and is not regarded under a foreign tax law but another amount 
connected to the payment (the connected amount) is regarded under such 
foreign tax law. For this purpose, a repo transaction means a 
transaction one or more payments with respect to which are treated as 
interest (as defined in Sec.  1.267A-5(a)(12)) or a structured payment 
(as defined in Sec.  1.267A-5(b)(5)(ii)) for U.S. tax purposes and that 
is a securities lending transaction or sale-repurchase transaction 
(including as described in Sec.  1.861-2(a)(7)), or other similar 
transaction or series of related transactions in which legal title to 
property is transferred and the property (or similar property, such as 
securities of the same class and issue) is reacquired or expected to be 
reacquired. For example, this paragraph (a)(3) applies if a specified 
payment arising from characterizing a repo transaction of stock in 
accordance with its substance (that is, characterizing the specified 
payment as interest) is not regarded as such under a foreign tax law 
but an amount consistent with the form of the transaction (such as a 
dividend) is regarded under such foreign tax law. When this paragraph 
(a)(3) applies, the determination of the identity of a specified 
recipient of the specified payment under the foreign tax law is made 
with respect to the connected amount. In addition, if the specified 
recipient includes the connected amount in income (as determined under 
Sec.  1.267A-3(a), by treating the connected amount as the specified 
payment), then the amount of the specified recipient's no-inclusion 
with respect to the specified payment is correspondingly reduced. See 
Sec.  1.267A-6(c)(2). Further, the principles of this paragraph (a)(3) 
apply to cases similar to repo transactions in which a foreign tax law 
does not characterize the transaction in accordance with its substance.
    (b) Disregarded payments--(1) In general. Subject to Sec.  1.267A-
3(b) (amounts included or includible in income), the excess (if any) of 
the sum of a specified party's disregarded payments for a taxable year 
over its dual inclusion income for the taxable year is a disqualified 
hybrid amount. See Sec.  1.267A-6(c)(3) and (4).
    (2) Definition of disregarded payment. The term disregarded payment 
means a specified payment to the extent that, under the tax law of a 
tax resident or taxable branch to which the payment is made, the 
payment is not regarded (for example, because under such tax law it is 
a disregarded transaction involving a single taxpayer or between group 
members) and, were the payment to be regarded (and treated as interest 
or a royalty, as applicable) under such tax law, the tax resident or 
taxable branch would include the payment in income, as determined under 
Sec.  1.267A-3(a). In addition, a disregarded payment includes a 
specified payment that, under the tax law of a tax resident or taxable 
branch to which the payment is made, is a payment that gives rise to a 
deduction or similar offset allowed to the tax resident or taxable 
branch (or group of entities that include the tax resident or taxable 
branch) under a foreign consolidation, fiscal unity, group relief, loss 
sharing, or any similar

[[Page 67638]]

regime. Moreover, a disregarded payment does not include a deemed 
branch payment, or a specified payment pursuant to a repo transaction 
or similar transaction described in paragraph (a)(3) of this section.
    (3) Definition of dual inclusion income. With respect to a 
specified party, the term dual inclusion income means the excess, if 
any, of--
    (i) The sum of the specified party's items of income or gain for 
U.S. tax purposes, to the extent the items of income or gain are 
included in the income of the tax resident or taxable branch to which 
the disregarded payments are made, as determined under Sec.  1.267A-
3(a) (by treating the items of income or gain as the specified 
payment); over
    (ii) The sum of the specified party's items of deduction or loss 
for U.S. tax purposes (other than deductions for disregarded payments), 
to the extent the items of deduction or loss are allowable (or have 
been or will be allowable during a taxable year that ends no more than 
36 months after the end of the specified party's taxable year) under 
the tax law of the tax resident or taxable branch to which the 
disregarded payments are made.
    (4) Payments made indirectly to a tax resident or taxable branch. A 
specified payment made to an entity an interest of which is directly or 
indirectly (determined under the rules of section 958(a) without regard 
to whether an intermediate entity is foreign or domestic) owned by a 
tax resident or taxable branch is considered made to the tax resident 
or taxable branch to the extent that, under the tax law of the tax 
resident or taxable branch, the entity to which the payment is made is 
fiscally transparent (and all intermediate entities, if any, are also 
fiscally transparent).
    (c) Deemed branch payments--(1) In general. If a specified payment 
is a deemed branch payment, then the payment is a disqualified hybrid 
amount if the tax law of the home office provides an exclusion or 
exemption for income attributable to the branch. See Sec.  1.267A-
6(c)(4).
    (2) Definition of deemed branch payment. The term deemed branch 
payment means, with respect to a U.S. taxable branch that is a U.S. 
permanent establishment of a treaty resident eligible for benefits 
under an income tax treaty between the United States and the treaty 
country, any amount of interest or royalties allowable as a deduction 
in computing the business profits of the U.S. permanent establishment, 
to the extent the amount is deemed paid to the home office (or other 
branch of the home office) and is not regarded (or otherwise taken into 
account) under the home office's tax law (or the other branch's tax 
law). A deemed branch payment may be otherwise taken into account for 
this purpose if, for example, under the home office's tax law a 
corresponding amount of interest or royalties is allocated and 
attributable to the U.S. permanent establishment and is therefore not 
deductible.
    (d) Payments to reverse hybrids--(1) In general. If a specified 
payment is made to a reverse hybrid, then, subject to Sec.  1.267A-3(b) 
(amounts included or includible in income), the payment is a 
disqualified hybrid amount to the extent that--
    (i) An investor of the reverse hybrid does not include the payment 
in income, as determined under Sec.  1.267A-3(a) (to such extent, a no-
inclusion); and
    (ii) The investor's no-inclusion is a result of the payment being 
made to the reverse hybrid. For this purpose, the investor's no-
inclusion is a result of the specified payment being made to the 
reverse hybrid to the extent that the no-inclusion would not occur were 
the investor's tax law to treat the reverse hybrid as fiscally 
transparent (and treat the payment as interest or a royalty, as 
applicable). See Sec.  1.267A-6(c)(5).
    (2) Definition of reverse hybrid. The term reverse hybrid means an 
entity (regardless of whether domestic or foreign) that is fiscally 
transparent under the tax law of the country in which it is created, 
organized, or otherwise established but not fiscally transparent under 
the tax law of an investor of the entity.
    (3) Payments made indirectly to a reverse hybrid. A specified 
payment made to an entity an interest of which is directly or 
indirectly (determined under the rules of section 958(a) without regard 
to whether an intermediate entity is foreign or domestic) owned by a 
reverse hybrid is considered made to the reverse hybrid to the extent 
that, under the tax law of an investor of the reverse hybrid, the 
entity to which the payment is made is fiscally transparent (and all 
intermediate entities, if any, are also fiscally transparent).
    (e) Branch mismatch payments--(1) In general. If a specified 
payment is a branch mismatch payment, then, subject to Sec.  1.267A-
3(b) (amounts included or includible in income), the payment is a 
disqualified hybrid amount to the extent that--
    (i) A home office, the tax law of which treats the payment as 
income attributable to a branch of the home office, does not include 
the payment in income, as determined under Sec.  1.267A-3(a) (to such 
extent, a no-inclusion); and
    (ii) The home office's no-inclusion is a result of the payment 
being a branch mismatch payment. For this purpose, the home office's 
no-inclusion is a result of the specified payment being a branch 
mismatch payment to the extent that the no-inclusion would not occur 
were the home office's tax law to treat the payment as income that is 
not attributable a branch of the home office (and treat the payment as 
interest or a royalty, as applicable). See Sec.  1.267A-6(c)(6).
    (2) Definition of branch mismatch payment. The term branch mismatch 
payment means a specified payment for which the following requirements 
are satisfied:
    (i) Under a home office's tax law, the payment is treated as income 
attributable to a branch of the home office; and
    (ii) Either--
    (A) The branch is not a taxable branch; or
    (B) Under the branch's tax law, the payment is not treated as 
income attributable to the branch.
    (f) Relatedness or structured arrangement limitation. A specified 
recipient, a tax resident or taxable branch to which a specified 
payment is made, an investor, or a home office is taken into account 
for purposes of paragraphs (a), (b), (d), and (e) of this section, 
respectively, only if the specified recipient, the tax resident or 
taxable branch, the investor, or the home office, as applicable, is 
related (as defined in Sec.  1.267A-5(a)(14)) to the specified party or 
is a party to a structured arrangement (as defined in Sec.  1.267A-
5(a)(20)) pursuant to which the specified payment is made.


Sec.  1.267A-3  Income inclusions and amounts not treated as 
disqualified hybrid amounts.

    (a) Income inclusions--(1) General rule. For purposes of section 
267A, a tax resident or taxable branch includes in income a specified 
payment to the extent that, under the tax law of the tax resident or 
taxable branch--
    (i) It includes (or it will include during a taxable year that ends 
no more than 36 months after the end of the specified party's taxable 
year) the payment in its income or tax base at the full marginal rate 
imposed on ordinary income; and
    (ii) The payment is not reduced or offset by an exemption, 
exclusion, deduction, credit (other than for withholding tax imposed on 
the payment), or other similar relief particular to such type of 
payment.

[[Page 67639]]

Examples of such reductions or offsets include a participation 
exemption, a dividends received deduction, a deduction or exclusion 
with respect to a particular category of income (such as income 
attributable to a branch, or royalties under a patent box regime), and 
a credit for underlying taxes paid by a corporation from which a 
dividend is received. A specified payment is not considered reduced or 
offset by a deduction or other similar relief particular to the type of 
payment if it is offset by a generally applicable deduction or other 
tax attribute, such as a deduction for depreciation or a net operating 
loss. For this purpose, a deduction may be treated as being generally 
applicable even if it is arises from a transaction related to the 
specified payment (for example, if the deduction and payment are in 
connection with a back-to-back financing arrangement).
    (2) Coordination with foreign hybrid mismatch rules. Whether a tax 
resident or taxable branch includes in income a specified payment is 
determined without regard to any defensive or secondary rule contained 
in hybrid mismatch rules, if any, under the tax law of the tax resident 
or taxable branch. For this purpose, a defensive or secondary rule 
means a provision of hybrid mismatch rules that requires a tax resident 
or taxable branch to include an amount in income if a deduction for the 
amount is not disallowed under applicable tax law.
    (3) Inclusions with respect to reverse hybrids. With respect to a 
tax resident or taxable branch that is an investor of a reverse hybrid, 
whether the investor includes in income a specified payment made to the 
reverse hybrid is determined without regard to a distribution from the 
reverse hybrid (or right to a distribution from the reverse hybrid 
triggered by the payment).
    (4) De minimis inclusions and deemed full inclusions. A 
preferential rate, exemption, exclusion, deduction, credit, or similar 
relief particular to a type of payment that reduces or offsets 90 
percent or more of the payment is considered to reduce or offset 100 
percent of the payment. In addition, a preferential rate, exemption, 
exclusion, deduction, credit, or similar relief particular to a type of 
payment that reduces or offsets 10 percent or less of the payment is 
considered to reduce or offset none of the payment.
    (b) Certain amounts not treated as disqualified hybrid amounts to 
extent included or includible in income--(1) In general. A specified 
payment, to the extent that but for this paragraph (b) it would be a 
disqualified hybrid amount (such amount, a tentative disqualified 
hybrid amount), is reduced under the rules of paragraphs (b)(2) through 
(4) of this section, as applicable. The tentative disqualified hybrid 
amount, as reduced under such rules, is the disqualified hybrid amount. 
See Sec.  1.267A-6(c)(3) and (7).
    (2) Included in income of United States tax resident or U.S. 
taxable branch. A tentative disqualified hybrid amount is reduced to 
the extent that a specified recipient that is a tax resident of the 
United States or a U.S. taxable branch takes the tentative disqualified 
hybrid amount into account in its gross income.
    (3) Includible in income under section 951(a)(1). A tentative 
disqualified hybrid amount is reduced to the extent that the tentative 
disqualified hybrid amount is received by a CFC and includible under 
section 951(a)(1) (determined without regard to properly allocable 
deductions of the CFC and qualified deficits under section 
952(c)(1)(B)) in the gross income of a United States shareholder of the 
CFC. However, the tentative disqualified hybrid amount is reduced only 
if the United States shareholder is a tax resident of the United States 
or, if the United States shareholder is not a tax resident of the 
United States, then only to the extent that a tax resident of the 
United States would take into account the amount includible under 
section 951(a)(1) in the gross income of the United States shareholder.
    (4) Includible in income under section 951A(a). A tentative 
disqualified hybrid amount is reduced to the extent that the tentative 
disqualified hybrid amount increases a United States shareholder's pro 
rata share of tested income (within the meaning of section 
951A(c)(2)(A)) with respect to a CFC, reduces the shareholder's pro 
rata share of tested loss (within the meaning of section 951A(c)(2)(B)) 
of the CFC, or both. However, the tentative disqualified hybrid amount 
is reduced only if the United States shareholder is a tax resident of 
the United States or, if the United States shareholder is not a tax 
resident of the United States, then only to the extent that a tax 
resident of the United States would take into account the amount that 
increases the United States shareholder's pro rata share of tested 
income with respect to the CFC, reduces the shareholder's pro rata 
share of tested loss of the CFC, or both.


Sec.  1.267A-4  Disqualified imported mismatch amounts.

    (a) Disqualified imported mismatch amounts. A specified payment (to 
the extent not a disqualified hybrid amount, as described in Sec.  
1.267A-2) is a disqualified imported mismatch amount to the extent 
that, under the set-off rules of paragraph (c) of this section, the 
income attributable to the payment is directly or indirectly offset by 
a hybrid deduction incurred by a tax resident or taxable branch that is 
related to the specified party (or that is a party to a structured 
arrangement pursuant to which the payment is made). For purposes of 
this section, any specified payment (to the extent not a disqualified 
hybrid amount) is referred to as an imported mismatch payment; the 
specified party is referred to as an imported mismatch payer; and a tax 
resident or taxable branch that includes the imported mismatch payment 
in income (or a tax resident or taxable branch the tax law of which 
otherwise prevents the imported mismatch payment from being a 
disqualified hybrid amount, for example, because under such tax law the 
tax resident's no-inclusion is not a result of hybridity) is referred 
to as the imported mismatch payee. See Sec.  1.267A-6(c)(8), (9), and 
(10).
    (b) Hybrid deduction. A hybrid deduction means, with respect to a 
tax resident or taxable branch that is not a specified party, a 
deduction allowed to the tax resident or taxable branch under its tax 
law for an amount paid or accrued that is interest (including an amount 
that would be a structured payment under the principles of Sec.  
1.267A-5(b)(5)(ii)) or royalty under such tax law (regardless of 
whether or how such amounts would be recognized under U.S. law), to the 
extent that a deduction for the amount would be disallowed if such tax 
law contained rules substantially similar to those under Sec. Sec.  
1.267A-1 through 1.267A-3 and 1.267A-5. In addition, with respect to a 
tax resident that is not a specified party, a hybrid deduction includes 
a deduction allowed to the tax resident with respect to equity, such as 
a notional interest deduction. Further, a hybrid deduction for a 
particular accounting period includes a loss carryover from another 
accounting period, to the extent that a hybrid deduction incurred in an 
accounting period beginning on or after December 20, 2018 comprises the 
loss carryover.
    (c) Set-off rules--(1) In general. In the order described in 
paragraph (c)(2) of this section, a hybrid deduction directly or 
indirectly offsets the income attributable to an imported mismatch 
payment to the extent that, under paragraph (c)(3) of this section, the 
payment directly or indirectly funds the hybrid deduction.

[[Page 67640]]

    (2) Ordering rules. The following ordering rules apply for purposes 
of determining the extent that a hybrid deduction directly or 
indirectly offsets income attributable to imported mismatch payments.
    (i) First, the hybrid deduction offsets income attributable to a 
factually-related imported mismatch payment that directly or indirectly 
funds the hybrid deduction. For this purpose, a factually-related 
imported mismatch payment means an imported mismatch payment that is 
made pursuant to a transaction, agreement, or instrument entered into 
pursuant to the same plan or series of related transactions that 
includes the transaction, agreement, or instrument pursuant to which 
the hybrid deduction is incurred.
    (ii) Second, to the extent remaining, the hybrid deduction offsets 
income attributable to an imported mismatch payment (other than a 
factually-related imported mismatch payment) that directly funds the 
hybrid deduction.
    (iii) Third, to the extent remaining, the hybrid deduction offsets 
income attributable to an imported mismatch payment (other than a 
factually-related imported mismatch payment) that indirectly funds the 
hybrid deduction.
    (3) Funding rules. The following funding rules apply for purposes 
of determining the extent that an imported mismatch payment directly or 
indirectly funds a hybrid deduction.
    (i) The imported mismatch payment directly funds a hybrid deduction 
to the extent that the imported mismatch payee incurs the deduction.
    (ii) The imported mismatch payment indirectly funds a hybrid 
deduction to the extent that the imported mismatch payee is allocated 
the deduction.
    (iii) The imported mismatch payee is allocated a hybrid deduction 
to the extent that the imported mismatch payee directly or indirectly 
makes a funded taxable payment to the tax resident or taxable branch 
that incurs the hybrid deduction.
    (iv) An imported mismatch payee indirectly makes a funded taxable 
payment to the tax resident or taxable branch that incurs a hybrid 
deduction to the extent that a chain of funded taxable payments exists 
connecting the imported mismatch payee, each intermediary tax resident 
or taxable branch, and the tax resident or taxable branch that incurs 
the hybrid deduction.
    (v) The term funded taxable payment means, with respect to a tax 
resident or taxable branch that is not a specified party, a deductible 
amount paid or accrued by the tax resident or taxable branch under its 
tax law, other than an amount that gives rise to a hybrid deduction. 
However, a funded taxable payment does not include an amount deemed to 
be an imported mismatch payment pursuant to paragraph (f) of this 
section.
    (vi) If, with respect to a tax resident or taxable branch that is 
not a specified party, a deduction or loss that is not incurred by the 
tax resident or taxable branch is directly or indirectly made available 
to offset income of the tax resident or taxable branch under its tax 
law, then, for purposes of this paragraph (c), the tax resident or 
taxable branch to which the deduction or loss is made available and the 
tax resident or branch that incurs the deduction or loss are treated as 
a single tax resident or taxable branch. For example, if a deduction or 
loss of one tax resident is made available to offset income of another 
tax resident under a tax consolidation, fiscal unity, group relief, 
loss sharing, or any similar regime, then the tax residents are treated 
as a single tax resident for purposes of paragraph (c) of this section.
    (d) Calculations based on aggregate amounts during accounting 
period. For purposes of this section, amounts are determined on an 
accounting period basis. Thus, for example, the amount of imported 
mismatch payments made by an imported mismatch payer to a particular 
imported mismatch payee is equal to the aggregate amount of all such 
payments made by the payer during the accounting period.
    (e) Pro rata adjustments. Amounts are allocated on a pro rata basis 
if there would otherwise be more than one permissible manner in which 
to allocate the amounts. Thus, for example, if multiple imported 
mismatch payers make an imported mismatch payment to a particular 
imported mismatch payee, the amount of such payments exceeds the hybrid 
deduction incurred by the payee, and the payments are not factually-
related imported mismatch payments, then a pro rata portion of each 
payer's payment is considered to directly fund the hybrid deduction. 
See Sec.  1.267A-6(c)(9).
    (f) Certain amounts deemed to be imported mismatch payments for 
certain purposes. For purposes of determining the extent that income 
attributable to an imported mismatch payment is directly or indirectly 
offset by a hybrid deduction, an amount paid or accrued by a tax 
resident or taxable branch that is not a specified party is deemed to 
be an imported mismatch payment (and such tax resident or taxable 
branch and a specified recipient of the amount, determined under Sec.  
1.267A-5(a)(19), by treating the amount as the specified payment, are 
deemed to be an imported mismatch payer and an imported mismatch payee, 
respectively) to the extent that--
    (1) The tax law of such tax resident or taxable branch contains 
hybrid mismatch rules; and
    (2) Under a provision of the hybrid mismatch rules substantially 
similar to this section, the tax resident or taxable branch is denied a 
deduction for all or a portion of the amount. See Sec.  1.267A-
6(c)(10).


Sec.  1.267A-5  Definitions and special rules.

    (a) Definitions. For purposes of Sec. Sec.  1.267A-1 through 
1.267A-7 the following definitions apply.
    (1) The term accounting period means a taxable year, or a period of 
similar length over which, under a provision of hybrid mismatch rules 
substantially similar to Sec.  1.267A-4, computations similar to those 
under that section are made under a foreign tax law.
    (2) The term branch means a taxable presence of a tax resident in a 
country other than its country of residence under either the tax 
resident's tax law or such other country's tax law.
    (3) The term branch mismatch payment has the meaning provided in 
Sec.  1.267A-2(e)(2).
    (4) The term controlled foreign corporation (or CFC) has the 
meaning provided in section 957.
    (5) The term deemed branch payment has the meaning provided in 
Sec.  1.267A-2(c)(2).
    (6) The term disregarded payment has the meaning provided in Sec.  
1.267A-2(b)(2).
    (7) The term entity means any person (as described in section 
7701(a)(1), including an entity that under Sec. Sec.  301.7701-1 
through 301.7701-3 of this chapter is disregarded as an entity separate 
from its owner) other than an individual.
    (8) The term fiscally transparent means, with respect to an entity, 
fiscally transparent with respect to an item of income as determined 
under the principles of Sec.  1.894-1(d)(3)(ii) and (iii), without 
regard to whether a tax resident (either the entity or interest holder 
in the entity) that derives the item of income is a resident of a 
country that has an income tax treaty with the United States.
    (9) The term home office means a tax resident that has a branch.
    (10) The term hybrid mismatch rules means rules, regulations, or 
other tax guidance substantially similar to section 267A, and includes 
rules the purpose of which is to neutralize the deduction/no-inclusion 
outcome of hybrid and branch mismatch arrangements. Examples of such 
rules would include rules based

[[Page 67641]]

on, or substantially similar to, the recommendations contained in OECD/
G-20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 
2: 2015 Final Report (October 2015), and OECD/G-20, Neutralising the 
Effects of Branch Mismatch Arrangements, Action 2: Inclusive Framework 
on BEPS (July 2017).
    (11) The term hybrid transaction has the meaning provided in Sec.  
1.267A-2(a)(2).
    (12) The term interest means any amount described in paragraph 
(a)(12)(i) or (ii) of this section (as adjusted by amounts described in 
paragraph (a)(12)(iii) of this section) that is paid or accrued, or 
treated as paid or accrued, for the taxable year or that is otherwise 
designated as interest expense in paragraph (a)(12)(i) or (ii) of this 
section (as adjusted by amounts described in paragraph (a)(12)(iii) of 
this section).
    (i) In general. Interest is an amount paid, received, or accrued as 
compensation for the use or forbearance of money under the terms of an 
instrument or contractual arrangement, including a series of 
transactions, that is treated as a debt instrument for purposes of 
section 1275(a) and Sec.  1.1275-1(d), and not treated as stock under 
Sec.  1.385-3, or an amount that is treated as interest under other 
provisions of the Internal Revenue Code (Code) or the regulations under 
26 CFR part 1. Thus, for example, interest includes--
    (A) Original issue discount (OID);
    (B) Qualified stated interest, as adjusted by the issuer for any 
bond issuance premium;
    (C) OID on a synthetic debt instrument arising from an integrated 
transaction under Sec.  1.1275-6;
    (D) Repurchase premium to the extent deductible by the issuer under 
Sec.  1.163-7(c);
    (E) Deferred payments treated as interest under section 483;
    (F) Amounts treated as interest under a section 467 rental 
agreement;
    (G) Forgone interest under section 7872;
    (H) De minimis OID taken into account by the issuer;
    (I) Amounts paid or received in connection with a sale-repurchase 
agreement treated as indebtedness under Federal tax principles; in the 
case of a sale-repurchase agreement relating to tax-exempt bonds, 
however, the amount is not tax-exempt interest;
    (J) Redeemable ground rent treated as interest under section 
163(c); and
    (K) Amounts treated as interest under section 636.
    (ii) Swaps with significant nonperiodic payments--(A) Non-cleared 
swaps. A swap that is not a cleared swap and that has significant 
nonperiodic payments is treated as two separate transactions consisting 
of an on-market, level payment swap and a loan. The loan must be 
accounted for by the parties to the contract independently of the swap. 
The time value component associated with the loan, determined in 
accordance with Sec.  1.446-3(f)(2)(iii)(A), is recognized as interest 
expense to the payor.
    (B) [Reserved]
    (C) Definition of cleared swap. The term cleared swap means a swap 
that is cleared by a derivatives clearing organization, as such term is 
defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a), or 
by a clearing agency, as such term is defined in section 3 of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c), that is registered as 
a derivatives clearing organization under the Commodity Exchange Act or 
as a clearing agency under the Securities Exchange Act of 1934, 
respectively, if the derivatives clearing organization or clearing 
agency requires the parties to the swap to post and collect margin or 
collateral.
    (iii) Amounts affecting the effective cost of borrowing that adjust 
the amount of interest expense. Income, deduction, gain, or loss from a 
derivative, as defined in section 59A(h)(4)(A), that alters a person's 
effective cost of borrowing with respect to a liability of the person 
is treated as an adjustment to interest expense of the person. For 
example, a person that is obligated to pay interest at a floating rate 
on a note and enters into an interest rate swap that entitles the 
person to receive an amount that is equal to or that closely 
approximates the interest rate on the note in exchange for a fixed 
amount is, in effect, paying interest expense at a fixed rate by 
entering into the interest rate swap. Income, deduction, gain, or loss 
from the swap is treated as an adjustment to interest expense. 
Similarly, any gain or loss resulting from a termination or other 
disposition of the swap is an adjustment to interest expense, with the 
timing of gain or loss subject to the rules of Sec.  1.446-4.
    (13) The term investor means, with respect to an entity, any tax 
resident or taxable branch that directly or indirectly (determined 
under the rules of section 958(a) without regard to whether an 
intermediate entity is foreign or domestic) owns an interest in the 
entity.
    (14) The term related has the meaning provided in this paragraph 
(a)(14). A tax resident or taxable branch is related to a specified 
party if the tax resident or taxable branch is a related person within 
the meaning of section 954(d)(3), determined by treating the specified 
party as the ``controlled foreign corporation'' referred to in that 
section and the tax resident or taxable branch as the ``person'' 
referred to in that section. In addition, for these purposes, a tax 
resident that under Sec. Sec.  301.7701-1 through 301.7701-3 of this 
chapter is disregarded as an entity separate from its owner for U.S. 
tax purposes, as well as a taxable branch, is treated as a corporation. 
Further, for these purposes neither section 318(a)(3), nor Sec.  1.958-
2(d) or the principles thereof, applies to attribute stock or other 
interests to a tax resident, taxable branch, or specified party.
    (15) The term reverse hybrid has the meaning provided in Sec.  
1.267A-2(d)(2).
    (16) The term royalty includes amounts paid or accrued as 
consideration for the use of, or the right to use--
    (i) Any copyright, including any copyright of any literary, 
artistic, scientific or other work (including cinematographic films and 
software);
    (ii) Any patent, trademark, design or model, plan, secret formula 
or process, or other similar property (including goodwill); or
    (iii) Any information concerning industrial, commercial or 
scientific experience, but does not include--
    (A) Amounts paid or accrued for after-sales services;
    (B) Amounts paid or accrued for services rendered by a seller to 
the purchaser under a warranty;
    (C) Amounts paid or accrued for pure technical assistance; or
    (D) Amounts paid or accrued for an opinion given by an engineer, 
lawyer or accountant.
    (17) The term specified party means a tax resident of the United 
States, a CFC (other than a CFC with respect to which there is not a 
United States shareholder that owns (within the meaning of section 
958(a)) at least ten percent (by vote or value) of the stock of the 
CFC), and a U.S. taxable branch. Thus, an entity that is fiscally 
transparent for U.S. tax purposes is not a specified party, though an 
owner of the entity may be a specified party. For example, in the case 
of a payment by a partnership, a domestic corporation or a CFC that is 
a partner of the partnership is a specified party whose deduction for 
its allocable share of the payment is subject to disallowance under 
section 267A.
    (18) The term specified payment has the meaning provided in Sec.  
1.267A-1(b).
    (19) The term specified recipient means, with respect to a 
specified payment, any tax resident that derives the payment under its 
tax law or any taxable branch to which the payment is

[[Page 67642]]

attributable under its tax law. The principles of Sec.  1.894-1(d)(1) 
apply for purposes of determining whether a tax resident derives a 
specified payment under its tax law, without regard to whether the tax 
resident is a resident of a country that has an income tax treaty with 
the United States. There may be more than one specified recipient with 
respect to a specified payment.
    (20) The term structured arrangement means an arrangement with 
respect to which one or more specified payments would be a disqualified 
hybrid amount (or a disqualified imported mismatch amount) if the 
specified payment were analyzed without regard to the relatedness 
limitation in Sec.  1.267A-2(f) (or without regard to the language 
``that is related to the specified party'' in Sec.  1.267A-4(a)) 
(either such outcome, a hybrid mismatch), provided that either 
paragraph (a)(20)(i) or (ii) of this section is satisfied. A party to a 
structured arrangement means a tax resident or taxable branch that 
participates in the structured arrangement. For this purpose, an 
entity's participation in a structured arrangement is imputed to its 
investors.
    (i) The hybrid mismatch is priced into the terms of the 
arrangement.
    (ii) Based on all the facts and circumstances, the hybrid mismatch 
is a principal purpose of the arrangement. Facts and circumstances that 
indicate the hybrid mismatch is a principal purpose of the arrangement 
include--
    (A) Marketing the arrangement as tax-advantaged where some or all 
of the tax advantage derives from the hybrid mismatch;
    (B) Primarily marketing the arrangement to tax residents of a 
country the tax law of which enables the hybrid mismatch;
    (C) Features that alter the terms of the arrangement, including the 
return, in the event the hybrid mismatch is no longer available; or
    (D) A below-market return absent the tax effects or benefits 
resulting from the hybrid mismatch.
    (21) The term tax law of a country includes statutes, regulations, 
administrative or judicial rulings, and treaties of the country. When 
used with respect to a tax resident or branch, tax law refers to--
    (i) In the case of a tax resident, the tax law of the country or 
countries where the tax resident is resident; and
    (ii) In the case of a branch, the tax law of the country where the 
branch is located.
    (22) The term taxable branch means a branch that has a taxable 
presence under its tax law.
    (23) The term tax resident means either of the following:
    (i) A body corporate or other entity or body of persons liable to 
tax under the tax law of a country as a resident. For this purpose, a 
body corporate or other entity or body of persons may be considered 
liable to tax under the tax law of a country as a resident even though 
such tax law does not impose a corporate income tax. A body corporate 
or other entity or body of persons may be a tax resident of more than 
one country.
    (ii) An individual liable to tax under the tax law of a country as 
a resident. An individual may be a tax resident of more than one 
country.
    (24) The term United States shareholder has the meaning provided in 
section 951(b).
    (25) The term U.S. taxable branch means a trade or business carried 
on in the United States by a tax resident of another country, except 
that if an income tax treaty applies, the term means a permanent 
establishment of a tax treaty resident eligible for benefits under an 
income tax treaty between the United States and the treaty country. 
Thus, for example, a U.S. taxable branch includes a U.S. trade or 
business of a foreign corporation taxable under section 882(a) or a 
U.S. permanent establishment of a tax treaty resident.
    (b) Special rules. For purposes of Sec. Sec.  1.267A-1 through 
1.267A-7, the following special rules apply.
    (1) Coordination with other provisions. Except as otherwise 
provided in the Code or in regulations under 26 CFR part 1, section 
267A applies to a specified payment after the application of any other 
applicable provisions of the Code and regulations under 26 CFR part 1. 
Thus, the determination of whether a deduction for a specified payment 
is disallowed under section 267A is made with respect to the taxable 
year for which a deduction for the payment would otherwise be allowed 
for U.S. tax purposes. See, for example, sections 163(e)(3) and 
267(a)(3) for rules that may defer the taxable year for which a 
deduction is allowed. See also Sec.  1.882-5(a)(5) (providing that 
provisions that disallow interest expense apply after the application 
of Sec.  1.882-5). In addition, provisions that characterize amounts 
paid or accrued as something other than interest or royalty, such as 
Sec.  1.894-1(d)(2), govern the treatment of such amounts and therefore 
such amounts would not be treated as specified payments.
    (2) Foreign currency gain or loss. Except as set forth in this 
paragraph (b)(2), section 988 gain or loss is not taken into account 
under section 267A. Foreign currency gain or loss recognized with 
respect to a specified payment is taken into account under section 267A 
to the extent that a deduction for the specified payment is disallowed 
under section 267A, provided that the foreign currency gain or loss is 
described in Sec.  1.988-2(b)(4) (relating to exchange gain or loss 
recognized by the issuer of a debt instrument with respect to accrued 
interest) or Sec.  1.988-2(c) (relating to items of expense or gross 
income or receipts which are to be paid after the date accrued). If a 
deduction for a specified payment is disallowed under section 267A, 
then a proportionate amount of foreign currency loss under section 988 
with respect to the specified payment is also disallowed, and a 
proportionate amount of foreign currency gain under section 988 with 
respect to the specified payment reduces the amount of the 
disallowance. For this purpose, the proportionate amount is the amount 
of the foreign currency gain or loss under section 988 with respect to 
the specified payment multiplied by the amount of the specified payment 
for which a deduction is disallowed under section 267A.
    (3) U.S. taxable branch payments--(i) Amounts considered paid or 
accrued by a U.S. taxable branch. For purposes of section 267A, a U.S. 
taxable branch is considered to pay or accrue an amount of interest or 
royalty equal to--
    (A) The amount of interest or royalty allocable to effectively 
connected income of the U.S. taxable branch under section 873(a) or 
882(c)(1), as applicable; or
    (B) In the case of a U.S. taxable branch that is a U.S. permanent 
establishment of a treaty resident eligible for benefits under an 
income tax treaty between the United States and the treaty country, the 
amount of interest or royalty deductible in computing the business 
profits attributable to the U.S. permanent establishment, if such 
amounts differ from the amounts allocable under paragraph (b)(3)(i)(A) 
of this section.
    (ii) Treatment of U.S. taxable branch payments--(A) Interest. 
Interest considered paid or accrued by a U.S. taxable branch of a 
foreign corporation under paragraph (b)(3)(i) of this section is 
treated as a payment directly to the person to which the interest is 
payable, to the extent it is paid or accrued with respect to a 
liability described in Sec.  1.882-5(a)(1)(ii)(A) (resulting in 
directly allocable interest) or with respect to a U.S. booked 
liability, as defined in Sec.  1.882-5(d)(2). If the amount of interest 
allocable to the U.S. taxable branch exceeds the interest paid or

[[Page 67643]]

accrued on its U.S. booked liabilities, the excess amount is treated as 
paid or accrued by the U.S. taxable branch on a pro-rata basis to the 
same persons and pursuant to the same terms that the home office paid 
or accrued interest for purposes of the calculations described in 
paragraph (b)(3)(i) of this section, excluding any interest treated as 
already paid directly by the branch.
    (B) Royalties. Royalties considered paid or accrued by a U.S. 
taxable branch under paragraph (b)(3)(i) of this section are treated 
solely for purposes of section 267A as paid or accrued on a pro-rata 
basis by the U.S. taxable branch to the same persons and pursuant to 
the same terms that the home office paid or accrued such royalties.
    (C) Permanent establishments and interbranch payments. If a U.S. 
taxable branch is a permanent establishment in the United States, rules 
analogous to the rules in paragraphs (b)(3)(ii)(A) and (B) of this 
section apply with respect to interest and royalties allowed in 
computing the business profits of a treaty resident eligible for treaty 
benefits. This paragraph (b)(3)(ii)(C) does not apply to interbranch 
interest or royalty payments allowed as deduction under certain U.S. 
income tax treaties (as described in Sec.  1.267A-2(c)(2)).
    (4) Effect on earnings and profits. The disallowance of a deduction 
under section 267A does not affect whether or when the amount paid or 
accrued that gave rise to the deduction reduces earnings and profits of 
a corporation.
    (5) Application to structured payments--(i) In general. For 
purposes of section 267A and the regulations under section 267A as 
contained in 26 CFR part 1, a structured payment (as defined in 
paragraph (b)(5)(ii) of this section) is treated as a specified 
payment.
    (ii) Structured payment. A structured payment means any amount 
described in paragraphs (b)(5)(ii)(A) or (B) of this section (as 
adjusted by amounts described in paragraph (b)(5)(ii)(C) of this 
section).
    (A) Certain payments related to the time value of money (structured 
interest amounts)--(1) Substitute interest payments. A substitute 
interest payment described in Sec.  1.861-2(a)(7).
    (2) Certain amounts labeled as fees--(i) Commitment fees. Any fees 
in respect of a lender commitment to provide financing if any portion 
of such financing is actually provided.
    (ii) [Reserved]
    (3) Debt issuance costs. Any debt issuance costs subject to Sec.  
1.446-5.
    (4) Guaranteed payments. Any guaranteed payments for the use of 
capital under section 707(c).
    (B) Amounts predominately associated with the time value of money. 
Any expense or loss, to the extent deductible, incurred by a person in 
a transaction or series of integrated or related transactions in which 
the person secures the use of funds for a period of time, if such 
expense or loss is predominately incurred in consideration of the time 
value of money.
    (C) Adjustment for amounts affecting the effective cost of funds. 
Income, deduction, gain, or loss from a derivative, as defined in 
section 59A(h)(4)(A), that alters a person's effective cost of funds 
with respect to a structured payment described in paragraph 
(b)(5)(ii)(A) or (B) of this section is treated as an adjustment to the 
structured payment of the person.
    (6) Anti-avoidance rule. A specified party's deduction for a 
specified payment is disallowed to the extent that both of the 
following requirements are satisfied:
    (i) The payment (or income attributable to the payment) is not 
included in the income of a tax resident or taxable branch, as 
determined under Sec.  1.267A-3(a) (but without regard to the de 
minimis and full inclusion rules in Sec.  1.267A-3(a)(3)).
    (ii) A principal purpose of the plan or arrangement is to avoid the 
purposes of the regulations under section 267A.


Sec.  1.267A-6   Examples.

    (a) Scope. This section provides examples that illustrate the 
application of Sec. Sec.  1.267A-1 through 1.267A-5.
    (b) Presumed facts. For purposes of the examples in this section, 
unless otherwise indicated, the following facts are presumed:
    (1) US1, US2, and US3 are domestic corporations that are tax 
residents solely of the United States.
    (2) FW, FX, and FZ are bodies corporate established in, and tax 
residents of, Country W, Country X, and Country Z, respectively. They 
are not fiscally transparent under the tax law of any country.
    (3) Under the tax law of each country, interest and royalty 
payments are deductible.
    (4) The tax law of each country provides a 100 percent 
participation exemption for dividends received from non-resident 
corporations.
    (5) The tax law of each country, other than the United States, 
provides an exemption for income attributable to a branch.
    (6) Except as provided in paragraphs (b)(4) and (5) of this 
section, all amounts derived (determined under the principles of Sec.  
1.894-1(d)(1)) by a tax resident, or attributable to a taxable branch, 
are included in income, as determined under Sec.  1.267A-3(a).
    (7) Only the tax law of the United States contains hybrid mismatch 
rules.

     (c) Examples--(1) Example 1. Payment pursuant to a hybrid 
financial instrument--(i) Facts. FX holds all the interests of US1. 
FX holds an instrument issued by US1 that is treated as equity for 
Country X tax purposes and indebtedness for U.S. tax purposes (the 
FX-US1 instrument). On date 1, US1 pays $50x to FX pursuant to the 
instrument. The amount is treated as an excludible dividend for 
Country X tax purposes (by reason of the Country X participation 
exemption) and as interest for U.S. tax purposes.
    (ii) Analysis. US1 is a specified party and thus a deduction for 
its $50x specified payment is subject to disallowance under section 
267A. As described in paragraphs (c)(1)(ii)(A) through (C) of this 
section, the entire $50x payment is a disqualified hybrid amount 
under the hybrid transaction rule of Sec.  1.267A-2(a) and, as a 
result, a deduction for the payment is disallowed under Sec.  
1.267A-1(b)(1).
    (A) US1's payment is made pursuant to a hybrid transaction 
because a payment with respect to the FX-US1 instrument is treated 
as interest for U.S. tax purposes but not for purposes of Country X 
tax law (the tax law of FX, a specified recipient that is related to 
US1). See Sec.  1.267A-2(a)(2) and (f). Therefore, Sec.  1.267A-2(a) 
applies to the payment.
    (B) For US1's payment to be a disqualified hybrid amount under 
Sec.  1.267A-2(a), a no-inclusion must occur with respect to FX. See 
Sec.  1.267A-2(a)(1)(i). As a consequence of the Country X 
participation exemption, FX includes $0 of the payment in income and 
therefore a $50x no-inclusion occurs with respect to FX. See Sec.  
1.267A-3(a)(1). The result is the same regardless of whether, under 
the Country X participation exemption, the $50x payment is simply 
excluded from FX's taxable income or, instead, is reduced or offset 
by other means, such as a $50x dividends received deduction. See id.
    (C) Pursuant to Sec.  1.267A-2(a)(1)(ii), FX's $50x no-inclusion 
gives rise to a disqualified hybrid amount to the extent that it is 
a result of US1's payment being made pursuant to the hybrid 
transaction. FX's $50x no-inclusion is a result of the payment being 
made pursuant to the hybrid transaction because, were the payment to 
be treated as interest for Country X tax purposes, FX would include 
$50x in income and, consequently, the no-inclusion would not occur.
    (iii) Alternative facts--multiple specified recipients. The 
facts are the same as in paragraph (c)(1)(i) of this section, except 
that FX holds all the interests of FZ, which is fiscally transparent 
for Country X tax purposes, and FZ holds all of the interests of 
US1. Moreover, the FX-US1 instrument is held by FZ (rather than by 
FX) and US1 makes its $50x payment to FZ (rather than to FX); the 
payment is derived by FZ under its tax law and by FX under its tax 
law and, accordingly, both FZ and FX are specified recipients of the 
payment. Further, the

[[Page 67644]]

payment is treated as interest for Country Z tax purposes and FZ 
includes it in income. For the reasons described in paragraph 
(c)(1)(ii) of this section, FX's no-inclusion causes the payment to 
be a disqualified hybrid amount. FZ's inclusion in income 
(regardless of whether Country Z has a low or high tax rate) does 
not affect the result, because the hybrid transaction rule of Sec.  
1.267A-2(a) applies if any no-inclusion occurs with respect to a 
specified recipient of the payment as a result of the payment being 
made pursuant to the hybrid transaction.
    (iv) Alternative facts--preferential rate. The facts are the 
same as in paragraph (c)(1)(i) of this section, except that for 
Country X tax purposes US1's payment is treated as a dividend 
subject to a 4% tax rate, whereas the marginal rate imposed on 
ordinary income is 20%. FX includes $10x of the payment in income, 
calculated as $50x multiplied by 0.2 (.04, the rate at which the 
particular type of payment (a dividend for Country X tax purposes) 
is subject to tax in Country X, divided by 0.2, the marginal tax 
rate imposed on ordinary income). See Sec.  1.267A-3(a)(1). Thus, a 
$40x no-inclusion occurs with respect to FX ($50x less $10x). The 
$40x no-inclusion is a result of the payment being made pursuant to 
the hybrid transaction because, were the payment to be treated as 
interest for Country X tax purposes, FX would include the entire 
$50x in income at the full marginal rate imposed on ordinary income 
(20%) and, consequently, the no-inclusion would not occur. 
Accordingly, $40x of US1's payment is a disqualified hybrid amount.
    (v) Alternative facts--no-inclusion not the result of hybridity. 
The facts are the same as in paragraph (c)(1)(i) of this section, 
except that Country X has a pure territorial regime (that is, 
Country X only taxes income with a domestic source). Although US1's 
payment is pursuant to a hybrid transaction and a $50x no-inclusion 
occurs with respect to FX, FX's no-inclusion is not a result of the 
payment being made pursuant to the hybrid transaction. This is 
because if Country X tax law were to treat the payment as interest, 
FX would include $0 in income and, consequently, the $50x no-
inclusion would still occur. Accordingly, US1's payment is not a 
disqualified hybrid amount. See Sec.  1.267A-2(a)(1)(ii). The result 
would be the same if Country X instead did not impose a corporate 
income tax.
     (2) Example 2. Payment pursuant to a repo transaction--(i) 
Facts. FX holds all the interests of US1, and US1 holds all the 
interests of US2. On date 1, US1 and FX enter into a sale and 
repurchase transaction. Pursuant to the transaction, US1 transfers 
shares of preferred stock of US2 to FX in return for $1,000x paid 
from FX to US1, subject to a binding commitment of US1 to reacquire 
those shares on date 3 for an agreed price, which represents a 
repayment of the $1,000x plus a financing or time value of money 
return reduced by the amount of any distributions paid with respect 
to the preferred stock between dates 1 and 3 that are retained by 
FX. On date 2, US2 pays a $100x dividend on its preferred stock to 
FX. For Country X tax purposes, FX is treated as owning the US2 
preferred stock and therefore is the beneficial owner of the 
dividend. For U.S. tax purposes, the transaction is treated as a 
loan from FX to US1 that is secured by the US2 preferred stock. 
Thus, for U.S. tax purposes, US1 is treated as owning the US2 
preferred stock and is the beneficial owner of the dividend. In 
addition, for U.S. tax purposes, US1 is treated as paying $100x of 
interest to FX (an amount corresponding to the $100x dividend paid 
by US2 to FX). Further, the marginal tax rate imposed on ordinary 
income under Country X tax law is 25%. Moreover, instead of a 
participation exemption, Country X tax law provides its tax 
residents a credit for underlying foreign taxes paid by a non-
resident corporation from which a dividend is received; with respect 
to the $100x dividend received by FX from US2, the credit is $10x.
    (ii) Analysis. US1 is a specified party and thus a deduction for 
its $100x specified payment is subject to disallowance under section 
267A. As described in paragraphs (c)(2)(ii)(A) through (D) of this 
section, $40x of the payment is a disqualified hybrid amount under 
the hybrid transaction rule of Sec.  1.267A-2(a) and, as a result, 
$40x of the deduction is disallowed under Sec.  1.267A-1(b)(1).
    (A) Although US1's $100x interest payment is not regarded under 
Country X tax law, a connected amount (US2's dividend payment) is 
regarded and derived by FX under such tax law. Thus, FX is 
considered a specified recipient with respect to US1's interest 
payment. See Sec.  1.267A-2(a)(3).
    (B) US1's payment is made pursuant to a hybrid transaction 
because a payment with respect to the sale and repurchase 
transaction is treated as interest for U.S. tax purposes but not for 
purposes of Country X tax law (the tax law of FX, a specified 
recipient that is related to US1), which does not regard the 
payment. See Sec.  1.267A-2(a)(2) and (f). Therefore, Sec.  1.267A-
2(a) applies to the payment.
    (C) For US1's payment to be a disqualified hybrid amount under 
Sec.  1.267A-2(a), a no-inclusion must occur with respect to FX. See 
Sec.  1.267A-2(a)(1)(i). As a consequence of Country X tax law not 
regarding US1's payment, FX includes $0 of the payment in income and 
therefore a $100x no-inclusion occurs with respect to FX. See Sec.  
1.267A-3(a). However, FX includes $60x of a connected amount (US2's 
dividend payment) in income, calculated as $100x (the amount of the 
dividend) less $40x (the portion of the connected amount that is not 
included in Country X due to the foreign tax credit, determined by 
dividing the amount of the credit, $10x, by 0.25, the tax rate in 
Country X). See id. Pursuant to Sec.  1.267A-2(a)(3), FX's inclusion 
in income with respect to the connected amount correspondingly 
reduces the amount of its no-inclusion with respect to US1's 
payment. Therefore, for purposes of Sec.  1.267A-2(a), FX's no-
inclusion with respect to US1's payment is considered to be $40x 
($100x less $60x). See Sec.  1.267A-2(a)(3).
    (D) Pursuant to Sec.  1.267A-2(a)(1)(ii), FX's $40x no-inclusion 
gives rise to a disqualified hybrid amount to the extent that FX's 
no-inclusion is a result of US1's payment being made pursuant to the 
hybrid transaction. FX's $40x no-inclusion is a result of US1's 
payment being made pursuant to the hybrid transaction because, were 
the sale and repurchase transaction to be treated as a loan from FX 
to US1 for Country X tax purposes, FX would include US1's $100x 
interest payment in income (because it would not be entitled to a 
foreign tax credit) and, consequently, the no-inclusion would not 
occur.
    (iii) Alternative facts--structured arrangement. The facts are 
the same as in paragraph (c)(2)(i) of this section, except that FX 
is a bank that is unrelated to US1. In addition, the sale and 
repurchase transaction is a structured arrangement and FX is a party 
to the structured arrangement. The result is the same as in 
paragraph (c)(2)(ii) of this section. That is, even though FX is not 
related to US1, it is taken into account with respect to the 
determinations under Sec.  1.267A-2(a) because it is a party to a 
structured arrangement pursuant to which the payment is made. See 
Sec.  1.267A-2(f).
     (3) Example 3. Disregarded payment--(i) Facts. FX holds all the 
interests of US1. For Country X tax purposes, US1 is a disregarded 
entity of FX. During taxable year 1, US1 pays $100x to FX pursuant 
to a debt instrument. The amount is treated as interest for U.S. tax 
purposes but is disregarded for Country X tax purposes as a 
transaction involving a single taxpayer. During taxable year 1, 
US1's only other items of income, gain, deduction, or loss are $125x 
of gross income and a $60x 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.
    (ii) Analysis. US1 is a specified party and thus a deduction for 
its $100x specified payment is subject to disallowance under section 
267A. As described in paragraphs (c)(3)(ii)(A) and (B) of this 
section, $35x of the payment is a disqualified hybrid amount under 
the disregarded payment rule of Sec.  1.267A-2(b) and, as a result, 
$35x of the deduction is disallowed under Sec.  1.267A-1(b)(1).
    (A) US1's $100x payment is not regarded under the tax law of 
Country X (the tax law of FX, a related tax resident to which the 
payment is made) because under such tax law the payment is a 
disregarded transaction involving a single taxpayer. See Sec.  
1.267A-2(b)(2) and (f). In addition, were the tax law of Country X 
to regard the payment (and treat it as interest), FX would include 
it in income. Therefore, the payment is a disregarded payment to 
which Sec.  1.267A-2(b) applies. See Sec.  1.267A-2(b)(2).
    (B) Under Sec.  1.267A-2(b)(1), the excess (if any) of US1's 
disregarded payments for taxable year 1 ($100x) over its dual 
inclusion income for the taxable year is a disqualified hybrid 
amount. US1's dual inclusion income for taxable year 1 is $65x, 
calculated as $125x (the amount of US1's gross income that is 
included in FX's income) less $60x (the amount of US1's deductible 
expenses, other than deductions for disregarded payments, that are 
allowable for Country X tax purposes). See Sec.  1.267A-2(b)(3). 
Therefore, $35x is a disqualified hybrid amount ($100x less $65x). 
See Sec.  1.267A-2(b)(1).
    (iii) Alternative facts--non-dual inclusion income arising from 
hybrid transaction. The

[[Page 67645]]

facts are the same as in paragraph (c)(3)(i) of this section, except 
that US1 holds all the interests of FZ (a CFC) and US1's only item 
of income, gain, deduction, or loss during taxable year 1 (other 
than the $100x payment to FX) is $80x paid to US1 by FZ pursuant to 
an instrument treated as indebtedness for U.S. tax purposes and 
equity for Country X tax purposes (the US1-FZ instrument). In 
addition, the $80x is treated as interest for U.S. tax purposes and 
an excludible dividend for Country X tax purposes (by reason of the 
Country X participation exemption). Paragraphs (c)(3)(iii)(A) and 
(B) of this section describe the extent to which the specified 
payments by FZ and US1, each of which is a specified party, are 
disqualified hybrid amounts.
    (A) The hybrid transaction rule of Sec.  1.267A-2(a) applies to 
FZ's payment because such payment is made pursuant to a hybrid 
transaction, as a payment with respect to the US1-FZ instrument is 
treated as interest for U.S. tax purposes but not for purposes of 
Country X's tax law (the tax law of FX, a specified recipient that 
is related to FZ). As a consequence of the Country X participation 
exemption, an $80x no-inclusion occurs with respect to FX, and such 
no-inclusion is a result of the payment being made pursuant to the 
hybrid transaction. Thus, but for Sec.  1.267A-3(b), the entire $80x 
of FZ's payment would be a disqualified hybrid amount. However, 
because US1 (a tax resident of the United States that is also a 
specified recipient of the payment) takes the entire $80x payment 
into account in its gross income, no portion of the payment is a 
disqualified hybrid amount. See Sec.  1.267A-3(b)(2).
    (B) The disregarded payment rule of Sec.  1.267A-2(b) applies to 
US1's $100x payment to FX, for the reasons described in paragraph 
(c)(3)(ii)(A) of this section. In addition, US1's dual inclusion 
income for taxable year 1 is $0 because, as a result of the Country 
X participation exemption, no portion of FZ's $80x payment to US1 
(which is derived by FX under its tax law) is included in FX's 
income. See Sec. Sec.  1.267A-2(b)(3) and 1.267A-3(a). Therefore, 
the entire $100x payment from US1 to FX is a disqualified hybrid 
amount, calculated as $100x (the amount of the payment) less $0 (the 
amount of dual inclusion income). See Sec.  1.267A-2(b)(1).
     (4) Example 4. Payment allocable to a U.S. taxable branch--(i) 
Facts. FX1 and FX2 are foreign corporations that are bodies 
corporate established in and tax residents of Country X. FX1 holds 
all the interests of FX2, and FX1 and FX2 file a consolidated return 
under Country X tax law. FX2 has a U.S. taxable branch (``USB''). 
During taxable year 1, FX2 pays $50x to FX1 pursuant to an 
instrument (the ``FX1-FX2 instrument''). The amount paid pursuant to 
the instrument is treated as interest for U.S. tax purposes but, as 
a consequence of the Country X consolidation regime, is treated as a 
disregarded transaction between group members for Country X tax 
purposes. Also during taxable year 1, FX2 pays $100x of interest to 
an unrelated bank that is not a party to a structured arrangement 
(the instrument pursuant to which the payment is made, the ``bank-
FX2 instrument''). FX2's only other item of income, gain, deduction, 
or loss for taxable year 1 is $200x of gross income. Under Country X 
tax law, the $200x of gross income is attributable to USB, but is 
not included in FX's income because Country X tax law exempts income 
attributable to a branch. Under U.S. tax law, the $200x of gross 
income is effectively connected income of USB. Further, under 
section 882, $75x of interest is, for taxable year 1, allocable to 
USB's effectively connected income. USB has neither liabilities that 
are directly allocable to it, as described in Sec.  1.882-
5(a)(1)(ii)(A), nor booked liabilities, as defined in Sec.  1.882-
5(d)(2).
    (ii) Analysis. USB is a specified party and thus any interest or 
royalty allowable as a deduction in determining its effectively 
connected income is subject to disallowance under section 267A. 
Pursuant to Sec.  1.267A-5(b)(3)(i)(A), USB is treated as paying 
$75x of interest, and such interest is thus a specified payment. Of 
that $75x, $25x is treated as paid to FX1, calculated as $75x (the 
interest allocable to USB under section 882) multiplied by \1/3\ 
($50x, FX2's payment to FX1, divided by $150x, the total interest 
paid by FX2). See Sec.  1.267A-5(b)(3)(ii)(A). As described in 
paragraphs (c)(4)(ii)(A) and (B) of this section, the $25x of the 
specified payment treated as paid by USB to FX1 is a disqualified 
hybrid amount under the disregarded payment rule of Sec.  1.267A-
2(b) and, as a result, a deduction for that amount is disallowed 
under Sec.  1.267A-1(b)(1).
    (A) USB's $25x payment to FX1 is not regarded under the tax law 
of Country X (the tax law of FX1, a related tax resident to which 
the payment is made) because under such tax law the payment is a 
disregarded transaction between group members. See Sec.  1.267A-
2(b)(2) and (f). In addition, were the tax law of Country X to 
regard the payment (and treat it as interest), FX1 would include it 
in income. Therefore, the payment is a disregarded payment to which 
Sec.  1.267A-2(b) applies. See Sec.  1.267A-2(b)(2).
    (B) Under Sec.  1.267A-2(b)(1), the excess (if any) of USB's 
disregarded payments for taxable year 1 ($25x) over its dual 
inclusion income for the taxable year is a disqualified hybrid 
amount. USB's dual inclusion income for taxable year 1 is $0. This 
is because, as a result of the Country X exemption for income 
attributable to a branch, no portion of USB's $200x item of gross 
income is included in FX2's income. See Sec.  1.267A-2(b)(3). 
Therefore, the entire $25x of the specified payment treated as paid 
by USB to FX1 is a disqualified hybrid amount, calculated as $25x 
(the amount of the payment) less $0 (the amount of dual inclusion 
income). See Sec.  1.267A-2(b)(1).
    (iii) Alternative facts--deemed branch payment. The facts are 
the same as in paragraph (c)(4)(i) of this section, except that FX2 
does not pay any amounts during taxable year 1 (thus, it does not 
pay the $50x to FX1 or the $100x to the bank). However, under an 
income tax treaty between the United States and Country X, USB is a 
U.S. permanent establishment and, for taxable year 1, $25x of 
royalties is allowable as a deduction in computing the business 
profits of USB and is deemed paid to FX2. Under Country X tax law, 
the $25x is not regarded. Accordingly, the $25x is a specified 
payment that is a deemed branch payment. See Sec. Sec.  1.267A-
2(c)(2) and 1.267A-5(b)(3)(i)(B). The entire $25x is a disqualified 
hybrid amount for which a deduction is disallowed because the tax 
law of Country X provides an exclusion or exemption for income 
attributable to a branch. See Sec.  1.267A-2(c)(1).
     (5) Example 5. Payment to a reverse hybrid--(i) Facts. FX holds 
all the interests of US1 and FY, and FY holds all the interests of 
FV. FY is an entity established in Country Y, and FV is an entity 
established in Country V. FY is fiscally transparent for Country Y 
tax purposes but is not fiscally transparent for Country X tax 
purposes. FV is fiscally transparent for Country X tax purposes. On 
date 1, US1 pays $100x to FY. The amount is treated as interest for 
U.S. tax purposes and Country X tax purposes.
    (ii) Analysis. US1 is a specified party and thus a deduction for 
its $100x specified payment is subject to disallowance under section 
267A. As described in paragraphs (c)(5)(ii)(A) through (C) of this 
section, the entire $100x payment is a disqualified hybrid amount 
under the reverse hybrid rule of Sec.  1.267A-2(d) and, as a result, 
a deduction for the payment is disallowed under Sec.  1.267A-
1(b)(1).
    (A) US1's payment is made to a reverse hybrid because FY is 
fiscally transparent under the tax law of Country Y (the tax law of 
the country in which it is established) but is not fiscally 
transparent under the tax law of Country X (the tax law of FX, an 
investor that is related to US1). See Sec.  1.267A-2(d)(2) and (f). 
Therefore, Sec.  1.267A-2(d) applies to the payment. The result 
would be the same if the payment were instead made to FV. See Sec.  
1.267A-2(d)(3).
    (B) For US1's payment to be a disqualified hybrid amount under 
Sec.  1.267A-2(d), a no-inclusion must occur with respect to FX. See 
Sec.  1.267A-2(d)(1)(i). Because FX does not derive the $100x 
payment under Country X tax law (as FY is not fiscally transparent 
under such tax law), FX includes $0 of the payment in income and 
therefore a $100x no-inclusion occurs with respect to FX. See Sec.  
1.267A-3(a).
    (C) Pursuant to Sec.  1.267A-2(d)(1)(ii), FX's $100x no-
inclusion gives rise to a disqualified hybrid amount to the extent 
that it is a result of US1's payment being made to the reverse 
hybrid. FX's $100x no-inclusion is a result of the payment being 
made to the reverse hybrid because, were FY to be treated as 
fiscally transparent for Country X tax purposes, FX would include 
$100x in income and, consequently, the no-inclusion would not occur. 
The result would be the same if Country X tax law instead viewed 
US1's payment as a dividend, rather than interest. See Sec.  1.267A-
2(d)(1)(ii).
    (iii) Alternative facts--inclusion under anti-deferral regime. 
The facts are the same as in paragraph (c)(5)(i) of this section, 
except that, under a Country X anti-deferral regime, FX includes in 
its income $100x attributable to the $100x payment received by FY. 
If under the rules of Sec.  1.267A-3(a) FX includes the entire 
attributed amount in income (that is, if FX includes the amount in 
its income at the full marginal rate imposed on ordinary

[[Page 67646]]

income and the amount is not reduced or offset by certain relief 
particular to the amount), then a no-inclusion does not occur with 
respect to FX. As a result, in such a case, no portion of US1's 
payment would be a disqualified hybrid amount under Sec.  1.267A-
2(d).
    (iv) Alternative facts--multiple investors. The facts are the 
same as in paragraph (c)(5)(i) of this section, except that FX holds 
all the interests of FZ, which is fiscally transparent for Country X 
tax purposes; FZ holds all the interests of FY, which is fiscally 
transparent for Country Z tax purposes; and FZ includes the $100x 
payment in income. Thus, each of FZ and FX is an investor of FY, as 
each directly or indirectly holds an interest of FY. See Sec.  
1.267A-5(a)(13). A no-inclusion does not occur with respect to FZ, 
but a $100x no-inclusion occurs with respect to FX. FX's no-
inclusion is a result of the payment being made to the reverse 
hybrid because, were FY to be treated as fiscally transparent for 
Country X tax purposes, then FX would include $100x in income (as FZ 
is fiscally transparent for Country X tax purposes). Accordingly, 
FX's no-inclusion is a result of US1's payment being made to the 
reverse hybrid and, consequently, the entire $100x payment is a 
disqualified hybrid amount.
    (v) Alternative facts--portion of no-inclusion not the result of 
hybridity. The facts are the same as in paragraph (c)(5)(i) of this 
section, except that the $100x is viewed as a royalty for U.S. tax 
purposes and Country X tax purposes, and Country X tax law contains 
a patent box regime that provides an 80% deduction with respect to 
certain royalty income. If the payment would qualify for the Country 
X patent box deduction were FY to be treated as fiscally transparent 
for Country X tax purposes, then only $20x of FX's $100x no-
inclusion would be the result of the payment being paid to a reverse 
hybrid, calculated as $100x (the no-inclusion with respect to FX 
that actually occurs) less $80x (the no-inclusion with respect to FX 
that would occur if FY were to be treated as fiscally transparent 
for Country X tax purposes). See Sec.  1.267A-3(a). Accordingly, in 
such a case, only $20x of US1's payment would be a disqualified 
hybrid amount.
    (6) Example 6. Branch mismatch payment--(i) Facts. FX holds all 
the interests of US1 and FZ. FZ owns BB, a Country B branch that 
gives rise to a taxable presence in Country B under Country Z tax 
law but not under Country B tax law. On date 1, US1 pays $50x to FZ. 
The amount is treated as a royalty for U.S. tax purposes and Country 
Z tax purposes. Under Country Z tax law, the amount is treated as 
income attributable to BB and, as a consequence of County Z tax law 
exempting income attributable to a branch, is excluded from FZ's 
income.
    (ii) Analysis. US1 is a specified party and thus a deduction for 
its $50x specified payment is subject to disallowance under section 
267A. As described in paragraphs (c)(6)(ii)(A) through (C) of this 
section, the entire $50x payment is a disqualified hybrid amount 
under the branch mismatch rule of Sec.  1.267A-2(e) and, as a 
result, a deduction for the payment is disallowed under Sec.  
1.267A-1(b)(1).
    (A) US1's payment is a branch mismatch payment because under 
Country Z tax law (the tax law of FZ, a home office that is related 
to US1) the payment is treated as income attributable to BB, and BB 
is not a taxable branch (that is, under Country B tax law, BB does 
not give rise to a taxable presence). See Sec.  1.267A-2(e)(2) and 
(f). Therefore, Sec.  1.267A-2(e) applies to the payment. The result 
would be the same if instead BB were a taxable branch and, under 
Country B tax law, US1's payment were treated as income attributable 
to FZ and not BB. See Sec.  1.267A-2(e)(2).
    (B) For US1's payment to be a disqualified hybrid amount under 
Sec.  1.267A-2(e), a no-inclusion must occur with respect to FZ. See 
Sec.  1.267A-2(e)(1)(i). As a consequence of the Country Z branch 
exemption, FZ includes $0 of the payment in income and therefore a 
$50x no-inclusion occurs with respect to FZ. See Sec.  1.267A-3(a).
    (C) Pursuant to Sec.  1.267A-2(e)(1)(ii), FZ's $50x no-inclusion 
gives rise to a disqualified hybrid amount to the extent that it is 
a result of US1's payment being a branch mismatch payment. FZ's $50x 
no-inclusion is a result of the payment being a branch mismatch 
payment because, were the payment to not be treated as income 
attributable to BB for Country Z tax purposes, FZ would include $50x 
in income and, consequently, the no-inclusion would not occur.
    (7) Example 7. Reduction of disqualified hybrid amount for 
certain amounts includible in income--(i) Facts. US1 and FW hold 60% 
and 40%, respectively, of the interests of FX, and FX holds all the 
interests of FZ. Each of FX and FZ is a CFC. FX holds an instrument 
issued by FZ that it is treated as equity for Country X tax purposes 
and as indebtedness for U.S. tax purposes (the FX-FZ instrument). On 
date 1, FZ pays $100x to FX pursuant to the FX-FZ instrument. The 
amount is treated as a dividend for Country X tax purposes and as 
interest for U.S. tax purposes. In addition, pursuant to section 
954(c)(6), the amount is not foreign personal holding company income 
of FX. Further, under section 951A, the payment is included in FX's 
tested income. Lastly, Country X tax law provides an 80% 
participation exemption for dividends received from nonresident 
corporations and, as a result of such participation exemption, FX 
includes $20x of FZ's payment in income.
    (ii) Analysis. FZ, a CFC, is a specified party and thus a 
deduction for its $100x specified payment is subject to disallowance 
under section 267A. But for Sec.  1.267A-3(b), $80x of FZ's payment 
would be a disqualified hybrid amount (such amount, a ``tentative 
disqualified hybrid amount''). See Sec. Sec.  1.267A-2(a) and 
1.267A-3(b)(1). Pursuant to Sec.  1.267A-3(b), the tentative 
disqualified hybrid amount is reduced by $48x. See Sec.  1.267A-
3(b)(4). The $48x is the tentative disqualified hybrid amount to the 
extent that it increases US1's pro rata share of tested income with 
respect to FX under section 951A (calculated as $80x multiplied by 
60%). See id. Accordingly, $32x of FZ's payment ($80x less $48x) is 
a disqualified hybrid amount under Sec.  1.267A-2(a) and, as a 
result, $32x of the deduction is disallowed under Sec.  1.267A-
1(b)(1).
    (iii) Alternative facts--United States shareholder not a tax 
resident of the United States. The facts are the same as in 
paragraph (c)(7)(i) of this section, except that US1 is a domestic 
partnership, 90% of the interests of which are held by US2 and the 
remaining 10% of which are held by a foreign individual that is a 
nonresident alien (as defined in section 7701(b)(1)(B)). As is the 
case in paragraph (c)(7)(ii) of this section, $48x of the $80x 
tentative disqualified hybrid amount increases US1's pro rata share 
of the tested income of FX. However, US1 is not a tax resident of 
the United States. Thus, the $48x reduces the tentative disqualified 
hybrid amount only to the extent that the $48x would be taken into 
account by a tax resident of the United States. See Sec.  1.267A-
3(b)(4). US2 (a tax resident of the United States) would take into 
account $43.2x of such amount (calculated as $48x multiplied by 
90%). Thus, $36.8x of FZ's payment ($80x less $43.2x) is a 
disqualified hybrid amount under Sec.  1.267A-2(a). See id.
    (8) Example 8. Imported mismatch rule--direct offset--(i) Facts. 
FX holds all the interests of FW, and FW holds all the interests of 
US1. FX holds an instrument issued by FW that is treated as equity 
for Country X tax purposes and indebtedness for Country W tax 
purposes (the FX-FW instrument). FW holds an instrument issued by 
US1 that is treated as indebtedness for Country W and U.S. tax 
purposes (the FW-US1 instrument). In accounting period 1, FW pays 
$100x to FX pursuant to the FX-FW instrument. The amount is treated 
as an excludible dividend for Country X tax purposes (by reason of 
the Country X participation exemption) and as interest for Country W 
tax purposes. Also in accounting period 1, US1 pays $100x to FW 
pursuant to the FW-US1 instrument. The amount is treated as interest 
for Country W and U.S. tax purposes and is included in FW's income. 
The FX-FW instrument was not entered into pursuant to the same plan 
or series of related transactions pursuant to which the FW-US1 
instrument was entered into.
    (ii) Analysis. US1 is a specified party and thus a deduction for 
its $100x specified payment is subject to disallowance under section 
267A. The $100x payment is not a disqualified hybrid amount. In 
addition, FW's $100x deduction is a hybrid deduction because it is a 
deduction allowed to FW that results from an amount paid that is 
interest under Country W tax law, and were Country X law to have 
rules substantially similar to those under Sec. Sec.  1.267A-1 
through 1.267A-3 and 1.267A-5, a deduction for the payment would be 
disallowed (because under such rules the payment would be pursuant 
to a hybrid transaction and FX's no-inclusion would be a result of 
the hybrid transaction). See Sec. Sec.  1.267A-2(a) and 1.267A-4(b). 
Under Sec.  1.267A-4(a), US1's payment is an imported mismatch 
payment, US1 is an imported mismatch payer, and FW (the tax resident 
that includes the imported mismatch payment in income) is an 
imported mismatch payee. The imported mismatch payment is a 
disqualified imported mismatch amount to the extent that the income 
attributable to the payment is directly or indirectly offset by the 
hybrid deduction incurred by FX (a tax

[[Page 67647]]

resident that is related to US1). See Sec.  1.267A-4(a). Under Sec.  
1.267A-4(c)(1), the $100x hybrid deduction directly or indirectly 
offsets the income attributable to US1's imported mismatch payment 
to the extent that the payment directly or indirectly funds the 
hybrid deduction. The entire $100x of US1's payment directly funds 
the hybrid deduction because FW (the imported mismatch payee) incurs 
at least that amount of the hybrid deduction. See Sec.  1.267A-
4(c)(3)(i). Accordingly, the entire $100x payment is a disqualified 
imported mismatch amount under Sec.  1.267A-4(a) and, as a result, a 
deduction for the payment is disallowed under Sec.  1.267A-1(b)(2).
    (iii) Alternative facts--long-term deferral. The facts are the 
same as in paragraph (c)(8)(i) of this section, except that the FX-
FW instrument is treated as indebtedness for Country X and Country W 
tax purposes, and FW does not pay any amounts pursuant to the 
instrument during accounting period 1. In addition, under Country W 
tax law, FW is allowed to deduct interest under the FX-FW instrument 
as it accrues, whereas under Country X tax law FX does not recognize 
income under the FX-FW instrument until interest is paid. Further, 
FW accrues $100x of interest during accounting period 1, and FW will 
not pay such amount to FX for more than 36 months after the end of 
the accounting period. The results are the same as in paragraph 
(c)(8)(ii) of this section. That is, FW's $100x deduction is a 
hybrid deduction, see Sec. Sec.  1.267A-2(a), 1.267A-3(a), and 
1.267A-4(b), and the income attributable to US1's $100x imported 
mismatch payment is offset by the hybrid deduction for the reasons 
described in paragraph (c)(8)(ii) of this section. As a result, a 
deduction for the payment is disallowed under Sec.  1.267A-1(b)(2).
    (iv) Alternative facts--notional interest deduction. The facts 
are the same as in paragraph (c)(8)(i) of this section, except that 
the FX-FW instrument does not exist and thus FW does not pay any 
amounts to FX during accounting period 1. However, during accounting 
period 1, FW is allowed a $100x notional interest deduction with 
respect to its equity under Country W tax law. Pursuant to Sec.  
1.267A-4(b), FW's notional interest deduction is a hybrid deduction. 
The results are the same as in paragraph (c)(8)(ii) of this section. 
That is, the income attributable to US1's $100x imported mismatch 
payment is offset by FW's hybrid deduction for the reasons described 
in paragraph (c)(8)(ii) of this section. As a result, a deduction 
for the payment is disallowed under Sec.  1.267A-1(b)(2).
    (v) Alternative facts--foreign hybrid mismatch rules prevent 
hybrid deduction. The facts are the same as in paragraph (c)(8)(i) 
of this section, except that the tax law of Country W contains 
hybrid mismatch rules and under such rules FW is not allowed a 
deduction for the $100x that it pays to FX on the FX-FW instrument. 
The $100x paid by FW therefore does not give rise to a hybrid 
deduction. See Sec.  1.267A-4(b). Accordingly, because the income 
attributable to US1's payment is not directly or indirectly offset 
by a hybrid deduction, the payment is not a disqualified imported 
mismatch amount. Therefore, a deduction for the payment is not 
disallowed under Sec.  1.267A-2(b)(2).
    (9) Example 9. Imported mismatch rule--indirect offsets and pro 
rata allocations--(i) Facts. FX holds all the interests of FZ, and 
FZ holds all the interests of US1 and US2. FX has a Country B branch 
that, for Country X and Country B tax purposes, gives rise to a 
taxable presence in Country B and is therefore a taxable branch 
(``BB''). Under the Country B-Country X income tax treaty, BB is a 
permanent establishment entitled to deduct expenses properly 
attributable to BB for purposes of computing its business profits 
under the treaty. BB is deemed to pay a royalty to FX for the right 
to use intangibles developed by FX equal to cost plus y%. The deemed 
royalty is a deductible expense properly attributable to BB under 
the Country B-Country X income tax treaty. For Country X tax 
purposes, any transactions between BB and X are disregarded. The 
deemed royalty amount is equal to $80x during accounting period 1. 
In addition, an instrument issued by FZ to FX is properly reflected 
as an asset on the books and records of BB (the FX-FZ instrument). 
The FX-FZ instrument is treated as indebtedness for Country X, 
Country Z, and Country B tax purposes. In accounting period 1, FZ 
pays $80x pursuant to the FX-FZ instrument; the amount is treated as 
interest for Country X, Country Z, and Country B tax purposes, and 
is treated as income attributable to BB for Country X and Country B 
tax purposes (but, for Country X tax purposes, is excluded from FX's 
income as a consequence of the Country X exemption for income 
attributable to a branch). Further, in accounting period 1, US1 and 
US2 pay $60x and $40x, respectively, to FZ pursuant to instruments 
that are treated as indebtedness for Country Z and U.S. tax 
purposes; the amounts are treated as interest for Country Z and U.S. 
tax purposes and are included in FZ's income for Country Z tax 
purposes. Lastly, neither the instrument pursuant to which US1 pays 
the $60x nor the instrument pursuant to which US2 pays the $40x was 
entered into pursuant to a plan or series of related transactions 
that includes the transaction or agreement giving rise to BB's 
deduction for the deemed royalty.
    (ii) Analysis. US1 and US2 are specified parties and thus 
deductions for their specified payments are subject to disallowance 
under section 267A. Neither of the payments is a disqualified hybrid 
amount. In addition, BB's $80x deduction for the deemed royalty is a 
hybrid deduction because it is a deduction allowed to BB that 
results from an amount paid that is treated as a royalty under 
Country B tax law (regardless of whether a royalty deduction would 
be allowed under U.S. law), and were Country B tax law to have rules 
substantially similar to those under Sec. Sec.  1.267A-1 through 
1.267A-3 and 1.267A-5, a deduction for the payment would be 
disallowed because under such rules the payment would be a deemed 
branch payment and Country X has an exclusion for income 
attributable to a branch. See Sec. Sec.  1.267A-2(c) and 1.267A-
4(b). Under Sec.  1.267A-4(a), each of US1's and US2's payments is 
an imported mismatch payment, US1 and US2 are imported mismatch 
payers, and FZ (the tax resident that includes the imported mismatch 
payments in income) is an imported mismatch payee. The imported 
mismatch payments are disqualified imported mismatch amounts to the 
extent that the income attributable to the payments is directly or 
indirectly offset by the hybrid deduction incurred by BB (a taxable 
branch that is related to US1 and US2). See Sec.  1.267A-4(a). Under 
Sec.  1.267A-4(c)(1), the $80x hybrid deduction directly or 
indirectly offsets the income attributable to the imported mismatch 
payments to the extent that the payments directly or indirectly fund 
the hybrid deduction. Paragraphs (c)(9)(ii)(A) and (B) of this 
section describe the extent to which the imported mismatch payments 
directly or indirectly fund the hybrid deduction.
    (A) Neither US1's nor US2's payment directly funds the hybrid 
deduction because FZ (the imported mismatch payee) did not incur the 
hybrid deduction. See Sec.  1.267A-4(c)(3)(i). To determine the 
extent to which the payments indirectly fund the hybrid deduction, 
the amount of the hybrid deduction that is allocated to FZ must be 
determined. See Sec.  1.267A-4(c)(3)(ii). FZ is allocated the hybrid 
deduction to the extent that it directly or indirectly makes a 
funded taxable payment to BB (the taxable branch that incurs the 
hybrid deduction). See Sec.  1.267A-4(c)(3)(iii). The $80x that FZ 
pays pursuant to the FX-FZ instrument is a funded taxable payment of 
FZ to BB. See Sec.  1.267A-4(c)(3)(v). Therefore, because FZ makes a 
funded taxable payment to BB that is at least equal to the amount of 
the hybrid deduction, FZ is allocated the entire amount of the 
hybrid deduction. See Sec.  1.267A-4(c)(3)(iii).
    (B) But for US2's imported mismatch payment, the entire $60x of 
US1's imported mismatch payment would indirectly fund the hybrid 
deduction because FZ is allocated at least that amount of the hybrid 
deduction. See Sec.  1.267A-4(c)(3)(ii). Similarly, but for US1's 
imported mismatch payment, the entire $40x of US2's imported 
mismatch payment would indirectly fund the hybrid deduction because 
FZ is allocated at least that amount of the hybrid deduction. See 
id. However, because the sum of US1's and US2's imported mismatch 
payments to FZ ($100x) exceeds the hybrid deduction allocated to FZ 
($80x), pro rata adjustments must be made. See Sec.  1.267A-4(e). 
Thus, $48x of US1's imported mismatch payment is considered to 
indirectly fund the hybrid deduction, calculated as $80x (the amount 
of the hybrid deduction) multiplied by 60% ($60x, the amount of 
US1's imported mismatch payment to FZ, divided by $100x, the sum of 
the imported mismatch payments that US1 and US2 make to FZ). 
Similarly, $32x of US2's imported mismatch payment is considered to 
indirectly fund the hybrid deduction, calculated as $80x (the amount 
of the hybrid deduction) multiplied by 40% ($40x, the amount of 
US2's imported mismatch payment to FZ, divided by $100x, the sum of 
the imported mismatch payments that US1 and US2 make to FZ). 
Accordingly, $48x of US1's imported mismatch payment, and $32x of 
US2's imported mismatch payment, is a disqualified imported mismatch 
amount under Sec.  1.267A-4(a) and,

[[Page 67648]]

as a result, a deduction for such amounts is disallowed under Sec.  
1.267A-1(b)(2).
    (iii) Alternative facts--loss made available through foreign 
group relief regime. The facts are the same as in paragraph 
(c)(9)(i) of this section, except that FZ holds all the interests in 
FZ2, a body corporate that is a tax resident of Country Z, FZ2 
(rather than FZ) holds all the interests of US1 and US2, and US1 and 
US2 make their respective $60x and $40x payments to FZ2 (rather than 
to FZ). Further, in accounting period 1, a $10x loss of FZ is made 
available to offset income of FZ2 through a Country Z foreign group 
relief regime. Pursuant to Sec.  1.267A-4(c)(3)(vi), FZ and FZ2 are 
treated as a single tax resident for purposes of Sec.  1.267A-4(c) 
because a loss that is not incurred by FZ2 (FZ's $10x loss) is made 
available to offset income of FZ2 under the Country Z group relief 
regime. Accordingly, the results are the same as in paragraph 
(c)(9)(ii) of this section. That is, by treating FZ and FZ2 as a 
single tax resident for purposes of Sec.  1.267A-4(c), BB's hybrid 
deduction offsets the income attributable to US1's and US2's 
imported mismatch payments to the same extent as described in 
paragraph (c)(9)(ii) of this section.
    (10) Example 10. Imported mismatch rule--ordering rules and rule 
deeming certain payments to be imported mismatch payments--(i) 
Facts. FX holds all the interests of FW, and FW holds all the 
interests of US1, US2, and FZ. FZ holds all the interests of US3. FX 
advances money to FW pursuant to an instrument that is treated as 
equity for Country X tax purposes and indebtedness for Country W tax 
purposes (the FX-FW instrument). In a transaction that is pursuant 
to the same plan pursuant to which the FX-FW instrument is entered 
into, FW advances money to US1 pursuant to an instrument that is 
treated as indebtedness for Country W and U.S. tax purposes (the FW-
US1 instrument). In accounting period 1, FW pays $125x to FX 
pursuant to the FX-FW instrument; the amount is treated as an 
excludible dividend for Country X tax purposes (by reason of the 
Country X participation exemption regime) and as deductible interest 
for Country W tax purposes. Also in accounting period 1, US1 pays 
$50x to FW pursuant to the FW-US1 instrument; US2 pays $50x to FW 
pursuant to an instrument treated as indebtedness for Country W and 
U.S. tax purposes (the FW-US2 instrument); US3 pays $50x to FZ 
pursuant to an instrument treated as indebtedness for Country Z and 
U.S. tax purposes (the FZ-US3 instrument); and FZ pays $50x to FW 
pursuant to an instrument treated as indebtedness for Country W and 
Country Z tax purposes (FW-FZ instrument). The amounts paid by US1, 
US2, US3, and FZ are treated as interest for purposes of the 
relevant tax laws and are included in the respective specified 
recipient's income. Lastly, neither the FW-US2 instrument, the FW-FZ 
instrument, nor the FZ-US3 instrument was entered into pursuant to a 
plan or series of related transactions that includes the transaction 
pursuant to which the FX-FW instrument was entered into.
    (ii) Analysis. US1, US2, and US3 are specified parties (but FZ 
is not a specified party, see Sec.  1.267A-5(a)(17)) and thus 
deductions for US1's, US2's, and US3's specified payments are 
subject to disallowance under section 267A. None of the specified 
payments is a disqualified hybrid amount. Under Sec.  1.267A-4(a), 
each of the payments is thus an imported mismatch payment, US1, US2, 
and US3 are imported mismatch payers, and FW and FZ (the tax 
residents that include the imported mismatch payments in income) are 
imported mismatch payees. The imported mismatch payments are 
disqualified imported mismatch amounts to the extent that the income 
attributable to the payments is directly or indirectly offset by 
FW's $125x hybrid deduction. See Sec.  1.267A-4(a) and (b). Under 
Sec.  1.267A-4(c)(1), the $125x hybrid deduction directly or 
indirectly offsets the income attributable to the imported mismatch 
payments to the extent that the payments directly or indirectly fund 
the hybrid deduction. Paragraphs (c)(10)(ii)(A) through (C) of this 
section describe the extent to which the imported mismatch payments 
directly or indirectly fund the hybrid deduction and are therefore 
disqualified hybrid amounts for which a deduction is disallowed 
under Sec.  1.267A-1(b)(2).
    (A) First, the $125x hybrid deduction offsets the income 
attributable to US1's imported mismatch payment, a factually-related 
imported mismatch payment that directly funds the hybrid deduction. 
See Sec.  1.267A-4(c)(2)(i). The entire $50x of US1's payment 
directly funds the hybrid deduction because FW (the imported 
mismatch payee) incurs at least that amount of the hybrid deduction. 
See Sec.  1.267A-4(c)(3)(i). Accordingly, the entire $50x of the 
payment is a disqualified imported mismatch amount under Sec.  
1.267A-4(a).
    (B) Second, the remaining $75x hybrid deduction offsets the 
income attributable to US2's imported mismatch payment, a factually-
unrelated imported mismatch payment that directly funds the 
remaining hybrid deduction. Sec.  1.267A-4(c)(2)(ii). The entire 
$50x of US2's payment directly funds the remaining hybrid deduction 
because FW (the imported mismatch payee) incurs at least that amount 
of the remaining hybrid deduction. See Sec.  1.267A-4(c)(3)(i). 
Accordingly, the entire $50x of the payment is a disqualified 
imported mismatch amount under Sec.  1.267A-4(a).
    (C) Third, the $25x remaining hybrid deduction offsets the 
income attributable to US3's imported mismatch payment, a factually-
unrelated imported mismatch payment that indirectly funds the 
remaining hybrid deduction. See Sec.  1.267A-4(c)(2)(iii). The 
imported mismatch payment indirectly funds the remaining hybrid 
deduction to the extent that FZ (the imported mismatch payee) is 
allocated the remaining hybrid deduction. Sec.  1.267A-4(c)(3)(ii). 
FZ is allocated the remaining hybrid deduction to the extent that it 
directly or indirectly makes a funded taxable payment to FW (the tax 
resident that incurs the hybrid deduction). Sec.  1.267A-
4(c)(3)(iii). The $50x that FZ pays to FW pursuant to the FW-FZ 
instrument is a funded taxable payment of FZ to FW. Sec.  1.267A-
4(c)(3)(v). Therefore, because FZ makes a funded taxable payment to 
FW that is at least equal to the amount of the remaining hybrid 
deduction, FZ is allocated the remaining hybrid deduction. Sec.  
1.267A-4(c)(3)(iii). Accordingly, $25x of US3's payment indirectly 
funds the $25x remaining hybrid deduction and, consequently, $25x of 
US3's payment is a disqualified imported mismatch amount under Sec.  
1.267A-4(a).
    (iii) Alternative facts--amount deemed to be an imported 
mismatch payment. The facts are the same as in paragraph (c)(10)(i) 
of this section, except that US1 is not a domestic corporation but 
instead is a body corporate that is only a tax resident of Country E 
(hereinafter, ``FE'') (thus, for purposes of this paragraph 
(c)(10)(iii), the FW-US1 instrument is instead issued by FE and is 
the ``FW-FE instrument''). In addition, the tax law of Country E 
contains hybrid mismatch rules and, under a provision of such rules 
substantially similar to Sec.  1.267A-4, FE is denied a deduction 
for the $50x it pays to FW under the FW-FE instrument. Pursuant to 
Sec.  1.267A-4(f), the $50x that FE pays to FW pursuant to the FW-FE 
instrument is deemed to be an imported mismatch payment for purposes 
of determining the extent to which the income attributable to US2's 
and US3's imported mismatch payments is offset by FW's hybrid 
deduction. The results are the same as in paragraphs (c)(10)(ii)(B) 
and (C) of this section. That is, by treating the $50x that FE pays 
to FW as an imported mismatch payment, FW's hybrid deduction offsets 
the income attributable to US2's and US3's imported mismatch 
payments to the same extent as described in paragraphs 
(c)(10)(ii)(B) and (C) of this section.
    (iv) Alternative facts--amount deemed to be an imported mismatch 
payment not treated as a funded taxable payment. The facts are the 
same as in paragraph (c)(10)(i) of this section, except that FZ 
holds its interests of US3 indirectly through FE, a body corporate 
that is only a tax resident of Country E (hereinafter, ``FE''), and 
US3 makes its $50x payment to FE (rather than to FZ); US3's $50x 
payment is treated as interest for Country E tax purposes and FE 
includes the payment in income. In addition, during accounting 
period 1, FE pays $50x of interest to FZ pursuant to an instrument 
and such amount is included in FZ's income. Further, the tax law of 
Country E contains hybrid mismatch rules and, under a provision of 
such rules substantially similar to Sec.  1.267A-4, FE is denied a 
deduction for $25x of the $50x it pays to FZ, because under such 
provision $25x of the income attributable to FE's payment is 
considered offset against $25x of FW's hybrid deduction. With 
respect to US1 and US2, the results are the same as described in 
paragraphs (c)(10)(ii)(A) and (B) of this section. However, no 
portion of US3's payment is a disqualified imported mismatch amount. 
This is because the $50x that FE pays to FZ is not considered to be 
a funded taxable payment, because under a provision of Country E's 
hybrid mismatch rules that is substantially similar to Sec.  1.267A-
4, FE is denied a deduction for a portion of the $50x. See Sec.  
1.267A-4(c)(3)(v) and (f). Therefore, there is no chain of funded 
taxable payments connecting US3 (the imported mismatch payer) and FW 
(the tax resident that incurs the hybrid deduction); as a result, 
US3's payment does not indirectly

[[Page 67649]]

fund the hybrid deduction. See Sec.  1.267A-4(c)(3)(ii) through 
(iv).


Sec.  1.267A-7  Applicability dates.

    (a) General rule. Except as provided in paragraph (b) of this 
section, Sec. Sec.  1.267A-1 through 1.267A-6 apply to taxable years 
beginning after December 31, 2017.
    (b) Special rules. Sections 1.267A-2(b), (c), (e), 1.267A-4, and 
1.267A-5(b)(5) apply to taxable years beginning on or after December 
20, 2018. In addition, Sec.  1.267A-5(a)(20) (defining structured 
arrangement), as well as the portions of Sec. Sec.  1.267A-1 through 
1.267A-3 that relate to structured arrangements and that are not 
otherwise described in this paragraph (b), apply to taxable years 
beginning on or after December 20, 2018.
0
Par. 4. Section 1.1503(d)-1 is amended by:
0
1. In paragraph (b)(2)(i), removing the word ``and''.
0
2. In paragraph (b)(2)(ii), removing the second period and adding in 
its place ``; and''.
0
3. Adding paragraph (b)(2)(iii).
0
4. Redesignating paragraph (c) as paragraph (d).
0
5. Adding new paragraph (c).
0
6. In the first sentence of newly-redesignated paragraph (d)(2)(ii), 
removing the language ``(c)(2)(i)'' and adding the language 
``(d)(2)(i)'' in its place.
    The additions read as follows:


Sec.  1.1503(d)-1  Definitions and special rules for filings under 
section 1503(d).

* * * * *
    (b) * * *
    (2) * * *
    (iii) A domestic consenting corporation (as defined in Sec.  
301.7701-3(c)(3)(i) of this chapter), as provided in paragraph (c)(1) 
of this section. See Sec.  1.1503(d)-7(c)(41).
* * * * *
    (c) Treatment of domestic consenting corporation as a dual resident 
corporation--(1) Rule. A domestic consenting corporation is treated as 
a dual resident corporation under paragraph (b)(2)(iii) of this section 
for a taxable year if, on any day during the taxable year, the 
following requirements are satisfied:
    (i) Under the tax law of a foreign country where a specified 
foreign tax resident is tax resident, the specified foreign tax 
resident derives or incurs (or would derive or incur) items of income, 
gain, deduction, or loss of the domestic consenting corporation 
(because, for example, the domestic consenting corporation is fiscally 
transparent under such tax law).
    (ii) The specified foreign tax resident bears a relationship to the 
domestic consenting corporation that is described in section 267(b) or 
707(b). See Sec.  1.1503(d)-7(c)(41).
    (2) Definitions. The following definitions apply for purposes of 
this paragraph (c).
    (i) The term fiscally transparent means, with respect to a domestic 
consenting corporation or an intermediate entity, fiscally transparent 
as determined under the principles of Sec.  1.894-1(d)(3)(ii) and 
(iii), without regard to whether a specified foreign tax resident is a 
resident of a country that has an income tax treaty with the United 
States.
    (ii) The term specified foreign tax resident means a body corporate 
or other entity or body of persons liable to tax under the tax law of a 
foreign country as a resident.
* * * * *
0
Par. 5. Section 1.1503(d)-3 is amended by adding the language ``or 
(e)(3)'' after the language ``paragraph (e)(2)'' in paragraph (e)(1), 
and adding paragraph (e)(3) to read as follows:


Sec.  1.1503(d)-3  Foreign use.

* * * * *
    (e) * * *
    (3) Exception for domestic consenting corporations. Paragraph 
(e)(1) of this section will not apply so as to deem a foreign use of a 
dual consolidated loss incurred by a domestic consenting corporation 
that is a dual resident corporation under Sec.  1.1503(d)-1(b)(2)(iii).


Sec.  1.1503(d)-6  [Amended]

0
Par. 6. Section 1.1503(d)-6 is amended by:
0
1. Removing the language ``a foreign government'' and ``a foreign 
country'' in paragraph (f)(5)(i), and adding the language ``a 
government of a country'' and ``the country'' in their places, 
respectively.
0
2. Removing the language ``a foreign government'' in paragraph 
(f)(5)(ii), and adding the language ``a government of a country'' in 
its place.
0
3. Removing the language ``the foreign government'' in paragraph 
(f)(5)(iii), and adding the language ``a government of a country'' in 
its place.
0
Par. 7. Section 1.1503(d)-7 is amended by redesignating Examples 1 
through 40 as paragraphs (c)(1) through (40), respectively, and adding 
paragraph (c)(41) to read as follows:


Sec.  1.1503(d)-7  Examples.

* * * * *

    (c) * * *
    (41) Example 41. Domestic consenting corporation--treated as 
dual resident corporation--(i) Facts. FSZ1, a Country Z entity that 
is subject to Country Z tax on its worldwide income or on a 
residence basis and is classified as a foreign corporation for U.S. 
tax purposes, owns all the interests in DCC, a domestic eligible 
entity that has filed an election to be classified as an 
association. Under Country Z tax law, DCC is fiscally transparent. 
For taxable year 1, DCC's only item of income, gain, deduction, or 
loss is a $100x deduction and such deduction comprises a $100x net 
operating loss of DCC. For Country Z tax purposes, FSZ1's only item 
of income, gain, deduction, or loss, other than the $100x loss 
attributable to DCC, is $60x of operating income.
    (ii) Result. DCC is a domestic consenting corporation because by 
electing to be classified as an association, it consents to be 
treated as a dual resident corporation for purposes of section 
1503(d). See Sec.  301.7701-3(c)(3) of this chapter. For taxable 
year 1, DCC is treated as a dual resident corporation under Sec.  
1.1503(d)-1(b)(2)(iii) because FSZ1 (a specified foreign tax 
resident that bears a relationship to DCC that is described in 
section 267(b) or 707(b)) derives or incurs items of income, gain, 
deduction, or loss of DCC. See Sec.  1.1503(d)-1(c). FSZ1 derives or 
incurs items of income, gain, deduction, or loss of DCC because, 
under Country Z tax law, DCC is fiscally transparent. Thus, DCC has 
a $100x dual consolidated loss for taxable year 1. See Sec.  
1.1503(d)-1(b)(5). Because the loss is available to, and in fact 
does, offset income of FSZ1 under Country Z tax law, there is a 
foreign use of the dual consolidated loss in year 1. Accordingly, 
the dual consolidated loss is subject to the domestic use limitation 
rule of Sec.  1.1503(d)-4(b). The result would be the same if FSZ1 
were to indirectly own its DCC stock through an intermediate entity 
that is fiscally transparent under Country Z tax law, or if an 
individual were to wholly own FSZ1 and FSZ1 were a disregarded 
entity. In addition, the result would be the same if FSZ1 had no 
items of income, gain, deduction, or loss, other than the $100x loss 
attributable to DCC.
    (iii) Alternative facts--DCC not treated as a dual resident 
corporation. The facts are the same as in paragraph (c)(41)(i) of 
this section, except that DCC is not fiscally transparent under 
Country Z tax law and thus under Country Z tax law FSZ1 does not 
derive or incur items of income, gain, deduction, or loss of DCC. 
Accordingly, DCC is not treated as a dual resident corporation under 
Sec.  1.1503(d)-1(b)(2)(iii) for year 1 and, consequently, its $100x 
net operating loss in that year is not a dual consolidated loss.
    (iv) Alternative facts--mirror legislation. The facts are the 
same as in paragraph (c)(41)(i) of this section, except that, under 
provisions of Country Z tax law that constitute mirror legislation 
under Sec.  1.1503(d)-3(e)(1) and that are substantially similar to 
the recommendations in Chapter 6 of OECD/G-20, Neutralising the 
Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report 
(October 2015), Country Z tax law prohibits the $100x loss 
attributable to DCC from offsetting FSZ1's income that is not also 
subject to U.S. tax. As is the case in

[[Page 67650]]

paragraph (c)(41)(ii) of this section, DCC is treated as a dual 
resident corporation under Sec.  1.1503(d)-1(b)(2)(iii) for year 1 
and its $100x net operating loss is a dual consolidated loss. 
Pursuant to Sec.  1.1503(d)-3(e)(3), however, the dual consolidated 
loss is not deemed to be put to a foreign use by virtue of the 
Country Z mirror legislation. Therefore, DCC is eligible to make a 
domestic use election for the dual consolidated loss.

0
Par. 8. Section 1.1503(d)-8 is amended by removing the language ``Sec.  
1.1503(d)-1(c)'' and adding in its place the language ``Sec.  
1.1503(d)-1(d)'' wherever it appears in paragraphs (b)(3)(i) and (iii), 
and adding paragraphs (b)(6) and (7) to read as follows:


Sec.  1.1503(d)-8  Effective dates.

* * * * *
    (b) * * *
    (6) Rules regarding domestic consenting corporations. Section 
1.1503(d)-1(b)(2)(iii), (c), and (d), as well Sec.  1.1503(d)-3(e)(1) 
and (e)(3), apply to determinations under Sec. Sec.  1.1503(d)-1 
through 1.1503(d)-7 relating to taxable years ending on or after 
December 20, 2018. For taxable years ending before December 20, 2018, 
see Sec. Sec.  1.1503(d)-1(c) (previous version of Sec.  1.1503(d)-
1(d)) and 1.1503(d)-3(e)(1) (previous version of Sec.  1.1503(d)-
3(e)(1)) as contained in 26 CFR part 1 revised as of April 1, 2018.
    (7) Compulsory transfer triggering event exception. Sections 
1.1503(d)-6(f)(5)(i) through (iii) apply to transfers that occur on or 
after December 20, 2018. For transfers occurring before December 20, 
2018, see Sec.  1.1503(d)-6(f)(5)(i) through (iii) as contained in 26 
CFR part 1 revised as of April 1, 2018. However, taxpayers may 
consistently apply Sec.  1.1503(d)-6(f)(5)(i) through (iii) to 
transfers occurring before December 20, 2018.
0
Par. 9. Section 1.6038-2 is amended by adding paragraphs (f)(13) and 
(14) and adding a sentence at the end of paragraph (m) to read as 
follows:


Sec.  1.6038-2  Information returns required of United States persons 
with respect to annual accounting periods of certain foreign 
corporations beginning after December 31, 1962.

* * * * *
    (f) * * *
    (13) Amounts involving hybrid transactions or hybrid entities under 
section 267A. If for the annual accounting period, the corporation pays 
or accrues interest or royalties for which a deduction is disallowed 
under section 267A and the regulations under section 267A as contained 
in 26 CFR part 1, then Form 5471 (or successor form) must contain such 
information about the disallowance in the form and manner and to the 
extent prescribed by the form, instruction, publication, or other 
guidance published in the Internal Revenue Bulletin.
    (14) Hybrid dividends under section 245A. If for the annual 
accounting period, the corporation pays or receives a hybrid dividend 
or a tiered hybrid dividend under section 245A and the regulations 
under section 245A as contained in 26 CFR part 1, then Form 5471 (or 
successor form) must contain such information about the hybrid dividend 
or tiered hybrid dividend in the form and manner and to the extent 
prescribed by the form, instruction, publication, or other guidance 
published in the Internal Revenue Bulletin.
* * * * *
    (m) Applicability dates. * * * Paragraphs (f)(13) and (14) of this 
section apply with respect to information for annual accounting periods 
beginning on or after December 20, 2018.
0
Par. 10. Section 1.6038-3 is amended by:
0
1. Adding paragraph (g)(3).
0
2. Redesignating the final paragraph (1) of the section as paragraph 
(l), revising the paragraph heading for newly-designated paragraph (l), 
and adding a sentence to the end of newly-designated paragraph (l).
    The additions and revision read as follows:


Sec.  1.6038-3  Information returns required of certain United States 
persons with respect to controlled foreign partnerships (CFPs).

* * * * *
    (g) * * *
    (3) Amounts involving hybrid transactions or hybrid entities under 
section 267A. In addition to the information required pursuant to 
paragraphs (g)(1) and (2) of this section, if, during the partnership's 
taxable year for which the Form 8865 is being filed, the partnership 
paid or accrued interest or royalties for which a deduction is 
disallowed under section 267A and the regulations under section 267A as 
contained in 26 CFR part 1, the controlling fifty-percent partners must 
provide information about the disallowance in the form and manner and 
to the extent prescribed by Form 8865 (or successor form), instruction, 
publication, or other guidance published in the Internal Revenue 
Bulletin.
* * * * *
    (l) Applicability dates. * * * Paragraph (g)(3) of this section 
applies for taxable years of a foreign partnership beginning on or 
after December 20, 2018.
0
Par. 11. Section 1.6038A-2 is amended by adding paragraph (b)(5)(iii) 
and adding a sentence at the end of paragraph (g) to read as follows:


Sec.  1.6038A-2  Requirement of return.

* * * * *
    (b) * * *
    (5) * * *
    (iii) If, for the taxable year, a reporting corporation pays or 
accrues interest or royalties for which a deduction is disallowed under 
section 267A and the regulations under section 267A as contained in 26 
CFR part 1, then the reporting corporation must provide such 
information about the disallowance in the form and manner and to the 
extent prescribed by Form 5472 (or successor form), instruction, 
publication, or other guidance published in the Internal Revenue 
Bulletin.
* * * * *
    (g) * * * Paragraph (b)(5)(iii) of this section applies with 
respect to information for annual accounting periods beginning on or 
after December 20, 2018.

PART 301--PROCEDURE AND ADMINISTRATION

0
Paragraph 12. The authority citation for part 301 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

0
Par. 13. Section 301.7701-3 is amended by revising the sixth sentence 
of paragraph (a) and adding paragraph (c)(3) to read as follows:


Sec.  301.7701-3  Classification of certain business entities.

    (a) In general. * * * Paragraph (c) of this section provides rules 
for making express elections, including a rule under which a domestic 
eligible entity that elects to be classified as an association consents 
to be subject to the dual consolidated loss rules of section 1503(d).
* * * * *
    (c) * * *
    (3) Consent to be subject to section 1503(d)--(i) Rule. A domestic 
eligible entity that elects to be classified as an association consents 
to be treated as a dual resident corporation for purposes of section 
1503(d) (such an entity, a domestic consenting corporation), for any 
taxable year for which it is classified as an association and the 
condition set forth in Sec.  1.1503(d)-1(c)(1) of this chapter is 
satisfied.
    (ii) Transition rule--deemed consent. If, as a result of the 
applicability date relating to paragraph (c)(3)(i) of this section, a 
domestic eligible entity that is classified as an association has not

[[Page 67651]]

consented to be treated as a domestic consenting corporation pursuant 
to paragraph (c)(3)(i) of this section, then the domestic eligible 
entity is deemed to consent to be so treated as of its first taxable 
year beginning on or after December 20, 2019. The first sentence of 
this paragraph (c)(3)(ii) does not apply if the domestic eligible 
entity elects, on or after December 20, 2018 and effective before its 
first taxable year beginning on or after December 20, 2019, to be 
classified as a partnership or disregarded entity such that it ceases 
to be a domestic eligible entity that is classified as an association. 
For purposes of the election described in the second sentence of this 
paragraph (c)(3)(ii), the sixty month limitation under paragraph 
(c)(1)(iv) of this section is waived.
    (iii) Applicability date. The sixth sentence of paragraph (a) of 
this section and paragraph (c)(3)(i) of this section apply to a 
domestic eligible entity that on or after December 20, 2018 files an 
election to be classified as an association (regardless of whether the 
election is effective before December 20, 2018). Paragraph (c)(3)(ii) 
of this section applies as of December 20, 2018.
* * * * *

Kirsten Wielobob,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2018-27714 Filed 12-20-18; 4:15 pm]
BILLING CODE 4830-01-P