Sec. 894 Final Rules for Recharacterizing Deductible Payments

Sec. 894 final regulations address payments made by domestic reverse hybrid entities (DRHs). In certain cases, these regulations can characterize deductible payments that a DRH makes to a related foreign interest holder (RFIH) as non-deductible dividend payments. They are effective for payments that the DRH makes or receives after June 11, 2002.

Targeted Transactions

According to Regs. Sec. 1.894-1(d)(2)(ii)(B), the new recharacterization rules apply when:

1. A domestic entity makes a payment to a DRH that is treated as a dividend under either U.S. law or the laws of an RFIHs jurisdiction;

2. The laws of the RFIHs jurisdiction require it to separately account for its share of the payment to the DRH, on a current basis, whether or not distributed (see Regs. Sec. 1.894-1(d)(3)(iii));

3. The DRH makes a payment deductible for U.S. tax purposes to either:

(a) the RFIH or

(b) a person (wherever organized) whose income and losses are available under the law of the RFIHs jurisdiction, to offset those of the RFIH (i.e., a member of the DRHs consolidated group or some other entity eligible for group relief or other offset against the RFIHs income and losses); and

4. The deductible payment is eligible for a reduced withholding tax rate under an income tax treaty.

When applicable, Regs. Sec. 1.894-1(d)(2)(ii)(B)(1)(iii) will recharacterize all or a portion of an otherwise deductible payment as a Sec. 301(a) distribution, for all purposes of the Code and any income tax treaty. As a result, the DRH will lose the benefit of the deduction (or a portion thereof); the recharacterized payment will be subject to the withholding rate on dividends, rather than the rate on interest or royalties, even if the dividend withholding rate is less than the interest rate (e.g., under the U.S.-Canada treaty). The appropriate withholding rate on amounts recharacterized as dividends is determined under the treaty between the RFIHs home country and the U.S., even if the payment is actually made to a person described in 3.(b) above (e.g., a sister company), located in another jurisdiction.

Definition of Related Person

The recharacterization rules do not apply unless a U.S. entity makes a payment to a related DRH and the DRH makes a payment to either an RFIH or another person whose income and losses combine with the RFIHs, under the RFIHs tax jurisdiction.

A person is related to a DRH under Regs. Sec. 1.894-1(d)(2)(ii)(B)(4) if he or she meets the Sec. 267(b) or 707(b)(1) ownership requirements, except that the necessary ownership percentage is 80% (rather than the more-than-50% threshold). For this purpose, the Sec. 318 constructive-ownership rules apply; the Sec. 267(c) attribution rules will also apply to the extent they attribute ownership to persons to whom Sec. 318 does not. In the preamble, Treasury indicated that this ownership requirement is intended to minimize the possibility that a taxpayer may inadvertently establish a DRH structure subject to the recharacterization rules.

Amount Recharacterized

Generally, a DRHs payment to an RFIH is recharacterized as a dividend to the extent it does not exceed the aggregate of current or accumulated dividends that a domestic entity paid to the DRH and were included in the RFIHs income under foreign law (i.e., the payments described in 1, plus dividends paid to the DRH, treated as derived by other parties described in 3.(b) above, reduced by prior Sec. 301(c) distributions to the RFIH or other person described in 3.(b) above and by the DRHs payments that were previously recharacterized.

Example: A foreign parent, F, owns 100% of DRH D, and is a resident of country X, a treaty jurisdiction with no withholding tax on interest or royalties and a 5% withholding tax on dividends from wholly owned subsidiaries. D owns all of the stock of a U.S. operating company, U. U makes a $100 payment to D, treated as a dividend for X or U.S. tax purposes. X views F as receiving its proportionate share of the dividend paid by U to D. D then makes a $25 payment to F, which is deductible for U.S. tax purposes (e.g., an interest or royalty payment) and is eligible for a zero withholding rate under the U.S.-X tax treaty.

The new recharacterization rule applies, because (1) U is a related domestic entity that makes a dividend payment to D, (2) F is an RFIH that receives a deductible payment and (3) all the other requirements are met. The $25 payment to F will be treated as a dividend, because it is not in excess of Ps pro-rata share of the dividend that D received, which is includible in the RFIHs income under X law. The withholding rate on the $25 payment will be the applicable rate on dividends paid to F (5%), not the zero interest-withholding rate under the U.S.-X treaty.

Further, D is not entitled to a deduction for the payment to F (see Regs. Sec. 1.894-1(d)(2)(iii), Example 3). If D had made a $150 interest payment, instead of $25, to F, only $100 could have been recharacterized as a dividend, because that amount would not have exceeded Fs pro-rata share of prior dividends ($100) received by D. The remaining $50 of interest could have been deducted and would have qualified for the zero interest-withholding rate.

Clarifications

The final regulations clarify that the recharacterization rule generally does not apply to a DRHs deductible payments if they were:

• Made to an unrelated party (e.g., a bank that has made a loan to the DRH, and an RFIH has provided a guarantee);

• Made to another related company (e.g., sister company) whose income and losses are not available to offset those of the RFIH, under the RFIHs jurisdiction; or

• Not otherwise subject to withholding under the Code (e.g., certain payments of portfolio interest or payments under a short-term (i.e., less than six months) original issue discount obligation.

However anti-abuse rules (discussed below) allow the IRS to recharacterize certain related- and unrelated-party transactions, otherwise exempt from the recharacterization rules.

Anti-Abuse Rules

At its discretion, the IRS may recharacterize payments, not otherwise subject to recharacterization, under the Regs. Sec. 1.894-1(d)(2)(ii)(C) anti-abuse rules. While the anti-abuse rules adopted have been narrowed from the very broad rules of the proposed regulations, they may still create uncertainty in some DRH structures. In determining whether payments should be recharaterized as dividends, the IRS divides payments into two categories.

Payments to related persons. Under Regs. Sec. 1.894-1(d)(2)(ii)(C)(1), a payment made to a foreign person who is related to the DRH, but is neither an RFIH nor a person whose losses and income can offset those of the RFIH (e.g., an unconsolidated foreign sister corporation), is deemed made to the RFIH if it meets two conditions: the payment is (1) deductible by the DRH and (2) connected with one or more transactions, the effect of which is to avoid the recharacterization rule. Note: there is no guidance as to the types of transactions the IRS is contemplating. Thus, any transaction (not just a financing transaction) is game.

Payments to unrelated persons. According to Regs. Sec. 1.894-1(d)(2)(ii)(C)(2), a deductible payment made to an unrelated person may be treated as a dividend paid to an RFIH when the payment is part of a back-to-back financing arrangement, as defined in the conduit-financing regulations. Recharacterization is possible when:

• The RFIH can deduct the payment;

• The unrelated person makes a payment to the RFIH;

• Both payments are connected to a series of transactions that is a financing arrangement as defined in Regs. Sec. 1.881-3(a)(2)(i); and

• The transactions effectively avoid application of the recharacterization rule.

Thus, if a DRH borrowed from an unrelated bank in which an RFIH has an account, the IRS could recharacterize a payment made to the bank as a dividend if it determines that the arrangement will, in effect, avoid the recharacterization rule.

From Lisa Askenazy Felix, J.D., LL.M., Washington, DC