Hybrid Entities and Treaty Benefits

Final regulations (TD 8889) describe how the provisions of U.S. income tax treaties apply when U.S. entity classification laws conflict with a foreign country’s. The final regulations replace temporary regulations issued in 1997.

Final Regs. Sec. 1.894-1(d) clarifies the availability of treaty benefits for a U.S.-source income item paid to an entity treated as fiscally transparent under the laws of one or more jurisdictions for that income item. The regulations also clarify how to apply U.S. treaty provisions when U.S. entity classification laws conflict with a foreign treaty jurisdiction (i.e., a hybrid entity). The regulations apply for all U.S. income tax treaties, regardless of whether they contain partnership provisions. As with the temporary regulations, the final regulations only apply to U.S.-source income not effectively connected with a U.S. trade or business.

Under the temporary regulations, an entity could claim treaty benefits for an income item if (1) it was derived from a resident of an applicable treaty jurisdiction; (2) such resident was a beneficial owner of the income item; and (3) all other applicable requirements for benefits under the treaty were satisfied. Further, under the temporary regulations, an income item was treated as derived from a resident of a treaty jurisdiction only to the extent that such income was subject to tax in that resident’s hands.

The final regulations eliminate the terms “beneficial ownership” and “subject to tax” from the general rule. The beneficial ownership concept in the temporary regulations provided guidance for income items of hybrid entities under income tax treaties in light of the reference to “beneficial owner” found in the Sec. 1441 proposed regulations. However, under Prop. Regs. Sec. 1.1441-6, the definition of “beneficial owner” does not apply when there is a claim for a reduced rate of withholding under an income tax treaty. As such, the term does not require further clarification in the Sec. 894 final regulations. The concept of beneficial ownership, however, remains important in applying treaty benefits.

Commentators suggested the term “subject to tax” was ambiguous and could be interpreted as requiring that tax actually be paid, as opposed to requiring that the income item simply fall within the taxing jurisdiction of the residence country. The IRS and Treasury agreed that the term was ambiguous and changed the language. Under the final regulations, an income item becomes subject to the residence country’s taxing jurisdiction if it is derived from a resident of a treaty jurisdiction.

Derived by a Resident of a Treaty Jurisdiction

An income item may be derived either by the entity receiving it or the entity’s interest holders or, in certain circumstances, both. Regs. Sec. 1.894-1(d) provides three situations in which income is derived by a resident of a treaty jurisdiction. In the first situation, an entity derives an income item if it is not fiscally transparent as to the income item under the laws of the entity’s jurisdiction. The entity’s jurisdiction is generally the place of the entity’s organization.

In the second situation, regardless of whether an entity is fiscally transparent as to an income item under the laws of the entity’s jurisdiction, an interest holder in the entity may derive the income item if it can establish that, under the laws of the jurisdiction in which the interest holder is a resident, the entity is fiscally transparent as to the income item. Under this test, the interest holder must not be considered fiscally transparent as to the income item under its jurisdiction’s laws.

In the third situation, an income item paid to a type of entity specifically listed in a treaty as a resident of that treaty jurisdiction can be derived by a resident of that jurisdiction.

Fiscally Transparent

Determining whether an entity is fiscally transparent under the final regulations is similar to that of the temporary regulations, with several simplifying and clarifying changes. Under Regs. Sec. 1.894-1(d)(3)(ii), an entity is fiscally transparent under the law of its jurisdiction as to an income item, to the extent the jurisdiction’s laws require the character and source of the income to flow through separately to the entity’s interest holders on a current basis, whether or not there is a distribution. If interest holders do not separately account for an income item, it may still be fiscally transparent as to the income item, if the outcome is the same whether or not the holders separately state the item.

Under Regs. Sec. 1.894-1(d)(3)(iii), an entity is fiscally transparent under the laws of an interest holder’s jurisdiction as to an income item, to the extent the laws require the income’s character and source to flow through to the interest holders in that entity on a current basis, whether or not there is a distribution.

Changes to the Temp. Regs.

The final regulations addressed a number of issues raised by the temporary regulations. For example, when multiple jurisdictions exist, it is unclear which jurisdiction’s laws apply in determining an entity’s fiscal transparency. Under Regs. Sec 1.894-1(d)(3)(ii), an entity is fiscally transparent when it is invoking treaty benefits. Regs. Sec. 1.894-1(d)(3)(iii) applies when an entity’s interest holder is invoking treaty benefits.

Under the temporary regulations, the requirement to separately state income items was not consistent with U.S. tax rules applicable to partnerships. Under the final regulations, however, if interest holders do not separately take an income item into account, the entity may still be fiscally transparent as to that income item, if the outcome is the same whether or not the holder separately stated the item.

Finally, the temporary regulations were unclear as to whether fiscal transparency is an item-by-item determination or one made for the entity as a whole. Under the final regulations, fiscal transparency is determined on an income-item-by-income-item basis.

The final regulations also require that, for an entity to be fiscally transparent as to an income item, the item must be included in the interest holder’s income, regardless of whether the income is distributed.

The temporary regulations provided guidance on payments to entities treated as domestic corporations for U.S. income tax purposes, but treated as fiscally transparent under the laws of the interest holder’s jurisdiction (i.e., domestic, reverse hybrid entities). This rule was insufficient, particularly for income items paid by a domestic, reverse hybrid entity. The final regulations are similar to the temporary regulations. However, Treasury and the Service acknowledge that they are aware of certain abusive structures involving such entities and expect to issue guidance shortly.

Effective Date

The final regulations apply to income items paid on or after June 30, 2000. As such, withholding agents should consider the effect of the regulations on withholding obligations, including the need to obtain a new withholding certificate to confirm claims of treaty benefits for income items paid on or after this date.

From Michael W. Granberg, CPA, Oak Brook, IL