IRS Issues New Tax Regulations on Domestic Reverse Hybrid Entities

On June 11, 2002, the US Treasury Department issued final regulations relating to structured transactions involving so-called domestic reverse hybrid ("DRH") entities. The regulations, effective for payments made by a DRH on or after June 11 with respect to amounts received by the DRH on or after June 11, are largely consistent with, but liberalize, the proposed regulations on this topic issued February 27, 2001.

Transaction Description
In a typical transaction affected by the new regulations, a US corporation pays dividends to a DRH that is owned by a non-US parent. Under the laws of the parent’s jurisdiction, the DRH is treated as a fiscally transparent entity (income and loss flow through it to its owners) while, under US law, the DRH is treated as a taxable entity (i.e. one that is not fiscally transparent). As such, the dividend is eliminated for US purposes, but is treated as having been received by the foreign parent for purposes of the law of the parent’s jurisdiction. Commonly, under such foreign law, the dividends will not be taxable to the foreign parent due to an exemption regime, or the flow-through of foreign tax credits from the United States. When the cash received by the DRH is paid by it to the foreign parent, it is treated for US purposes as an interest payment, generally fully deductible in the US while commonly qualifying for an exemption from US withholding tax under a tax treaty. For foreign law purposes, the receipt of this payment generally is not taxable because it is ignored for tax purposes as a distribution from a fiscally transparent entity. As such, the structure achieves a US tax deduction (for interest), an exemption from US withholding tax (under the treaty) and no taxation in the foreign jurisdiction on receipt of the cash.

Regulatory Treatment
The regulations generally recharacterize the payments from the DRH as dividends rather than interest. This has the effect of denying an interest deduction and disqualifying the payment from the treaty benefits applicable to interest (although treaty benefits applicable to dividends, generally not as generous, still apply). The major technical issue raised by the proposed regulations and clarified by the final regulations relates to the anti-abuse rule that gave the IRS the discretion to apply the regulations to transactions that, although not technically covered by the literal language of the regulations, were designed to achieve tax results inconsistent with the purposes of the regulations. In the final regulations, that discretion has been narrowed and clarified. The final regulations also contain several other important revisions to the proposed regulations, including one clarifying that payments by a DRH to a related foreign person are not recharacterized from interest to dividends unless the related foreign person is an interest holder in the DRH or can consolidate income and loss with the interest holder for foreign tax purposes. In addition, the preamble to the regulations clarifies that the government’s intention was not to attack so-called "double-dip" transactions generally, but to help ensure that transactions involving treaty benefits are consistent with the purposes of treaties: to reduce or eliminate double taxation, but not all taxation.

For further information about the regulations, please contact Phil West at 202.429.6247 or Stan Smilack at 202.429.6464.