The Tax Section of the New York State Bar Association recently issued a report commenting on the appropriate application of treaty limitations to source-country taxation of business profits when the underlying income is earned by or through an entity that is fiscally transparent under the laws of one treaty partner but fiscally opaque under the other treaty partner’s laws (a hybrid entity).1
The basic principle of the hybrid entity regulations under section 894 of the Internal Revenue Code is that, when the entity classification laws of the United States and those of a foreign treaty jurisdiction conflict, treaty benefits are determined based on the treaty eligibility of the income in the hands of the person treated as deriving the income in that person’s home country (the Derived By Rule).
Regulations under section 894(c) currently address eligibility for income tax treaty relief principally with respect to the taxes imposed by sections 871(a)/881(a) (FDAP income) on items of income received by hybrid entities. They do not apply, however, to business profits derived by or through a hybrid entity. The statutory authority under section 894(c)(2) for regulations addressing income earned through a hybrid entity is not limited to FDAP income, and business profits would clearly be within the scope of the regulatory authority. The report contains the Tax Section’s recommendations and requests for guidance with respect to the potential application of the Derived By Rule to business profits earned by or through hybrid entities.
The report makes the following principal recommendations:
- Business Profits.
- As a policy matter, the report recommends that the Derived By Rule should be extended to business profits. Applying the Derived By Rule to business profits earned through certain types of hybrid entities, such as domestic hybrid entities, should be relatively straightforward and would reduce taxpayer uncertainty as well as limit the potential for government whipsaw.
- The report identifies reasons for and against extending the Derived By Rule to business profits earned through other structures, such as foreign reverse hybrid entities, because these scenarios raise a number of practical and administrative questions. If the Department of the Treasury and the IRS were to extend the Derived By Rule to these scenarios, even limited guidance on these issues would help reduce uncertainty.
- Tax-Exempt Income. The report recommends that the Derived By Rule be clarified to allow treaty benefits for income (whether FDAP or non-FDAP) of a hybrid entity that would have been exempt from tax in the country of the investor’s residence had it been earned directly (and had the same character as the underlying income).
- Branch Profits Tax.
- The report recommends that the Derived By Rule be applied without modification to the branch profits tax (BPT). This approach would deny treaty benefits for the BPT imposed on business profits earned through a domestic or foreign hybrid entity and would allow treaty benefits in the case of business profits earned through a foreign reverse hybrid.
- The report also identifies an alternative approach that would favor a modification to the Derived By Rule as it applies to the BPT on business profits earned through a domestic hybrid entity. Under this approach, the Derived By Rule would be applied to the BPT only if treaty benefits would have been available to the taxpayer under the Derived By Rule with respect to the dividend withholding tax had the business profits been earned through a domestic subsidiary and repatriated as dividends to the taxpayer.
- In the case of the BPT imposed on a foreign corporation with respect to business profits earned through a foreign hybrid entity, the report recommends that the foreign hybrid should be permitted to claim its own treaty benefits with respect to the BPT imposed on its corporate interest holder.
- Finally, the report reviews a number of additional considerations and alternative approaches for circumstances in which the BPT is imposed on a foreign reverse hybrid entity with treaty-eligible individual interest holders. While the report identifies more than one approach, it recommends an approach that would allow the individual interest holders to claim treaty benefits as a result of their status as individuals only if their portion of the effectively connected income earned by the foreign reverse hybrid is subject to tax at individual tax rates.
Proper tax planning can be highly effective in maximizing tax efficiencies for “inbound” investments by foreign investors in U.S. opportunities. Careful consideration should be given to the investment structure utilized and its impact on the availability of treaty benefits. Particular care should be given to the tax treaty analysis where the investing entity is classified differently under U.S. tax law than its classification under the residence country’s tax laws.
There is existing guidance regarding the availability of treaty benefits for FDAP income earned by or through hybrid entities. In contrast, there is substantial uncertainty under current law about treaty availability for business profits earned through hybrid entities. The issues are even more complicated when the income is business income derived from a U.S. trade or business and is subject to the U.S. BPT.