Reverse Hybrid Regulations Set New Rules for In-Bound Acquisitions
August 2002
On June 12, 2002, in an action that will profoundly affect "in-bound" acquisition structures, the U.S. Department of the Treasury finalized regulations under Code Section 894(c) relating to U.S. domestic reverse hybrids (DRH), Treasury Decision 8999. The section 1.894-1(d)(2)(ii) regulations address the perceived abuse of the U.S. check-the-box rules by foreign acquirers to convert dividend payments into deductible low withholding rate interest payments. The new regulations are effective for payments made on or after June 12, 2002.
Section 894(c) was amended in 1997 to prevent foreign persons from using hybrid entities—companies treated as transparent for U.S. purposes but not for foreign purposes—to reduce withholding rates under an otherwise applicable treaty. That section was enacted to prevent Canadian parent companies from inserting a U.S. LLC between them and their U.S. operating companies. Subsequent interest paid by the U.S. operating company to the LLC was deductible, subject to section 163(j) and other limitations, and eligible for reduced withholding rates under the treaty even though the Canadian parent could exclude the LLC distribution as a dividend from a U.S. corporation. Such structures abused the treaty, it was felt, because instead of avoiding double taxation, they resulted in double non-inclusion of income. The new statute denied reduced treaty withholding rate benefits where such recipient did not include the item in income in their home country. Regulations subsequently adopted in respect of section 894(c) reserved rules for the treatment of payments from domestic reverse hybrids that are technically outside the scope of the new provision. Proposed regulations for these domestic reverse hybrids were first published on February 27, 2001, and are adopted in final form with little substantive change by the Treasury’s action on June 12, 2002.
The domestic reverse hybrid regulations focus on transactions as shown in the following chart, where a U.S. entity treated as transparent under the laws of a foreign country checks the box to be treated as a corporation for U.S. tax purposes.
INSERT CHART HERE^
This arrangement has been used, for example, when foreign acquirers buy a U.S. corporation through a DRH such as a Delaware general partnership, which checks the box to be treated as a corporation and become the parent of the resulting U.S. consolidated group. The foreign acquirer, who presumably borrows its acquisition funding in its home country, may lend money to the DRH to fund the acquisition price. After the acquisition, the acquired operating company pays a dividend to the DRH, the parent of the U.S. consolidated group, which amount is excluded from income for U.S. tax purposes as an intra-group distribution. The DRH then pays deductible interest expense to the foreign owners (deductible subject to earnings stripping limits under section 163(j) or payment requirements under sections 267(a)(3) or 163(e)(3)), which under the most favorable U.S. treaties, e.g., United Kingdom, Germany, Netherlands and France, are exempt from U.S. withholding tax. For U.S. purposes, the consolidated group has received one interest deduction for servicing the acquisition financing and has transferred the money out of the U.S. with no withholding tax.
From the foreign country perspective, the DRH is viewed as a transparent entity. As a result, the interest holders are treated as receiving the dividend from the operating company directly, which might be effectively exempt from tax under a foreign law due to a participation exemption, a foreign income exclusion or a foreign tax credit that eliminates foreign country tax to the recipient. Interest income on the investor loan is either ignored as an inter-branch loan or offset by the investor’s share of the DRH’s interest expense. And the foreign acquirer who receives the excludable income from its U.S. acquisition is entitled to a second deduction in its own country for interest accrued on the acquisition loan from the bank. In sum, the foreign investors, by inserting a domestic reverse hybrid in the ownership chain, have converted nondeductible, high withholding rate dividends into deductible interest expense, exempt from U.S. withholding tax.
The new regulations broadly provide that deductible royalty or interest paid to foreign interest holders from dividends received by the DRH from 80 percent related U.S. operating subsidiary will be re-characterized as dividends for all purposes under the Code. This means that withholding tax is imposed at the dividend rate rather than at the generally lower interest rates. However, much more detrimental to the investor is that the interest is also re-characterized as dividend for U.S. domestic tax purposes, eliminating the otherwise available interest expense deduction. The regulations include anti-avoidance rules extending the rules to payments by a DRH to persons related to the foreign interest owner and to unrelated persons under circumstances reflecting a conduit arrangement. See Section 7701(l) and Reg. §1.881-3(a)(2).
The proposed regulations were subject to much commentary from bar association groups, many suggesting that the remedy was inappropriate and perhaps unauthorized. Some suggested that the special dividend definition based on foreign law treatment was unprecedented and, perhaps, vulnerable to anti-discrimination provisions of our treaties. More broadly, commentators felt that the abuse being attacked was not the inappropriate use of lower withholding rates by the insertion of the domestic reverse hybrid, but rather the creation of a double interest deduction, in the U.S. as well as the foreign jurisdiction, by manipulating the inconsistent characterization of the DRH entity. This double deduction, these commentators argued, might be better attacked under the U.S. dual consolidated loss regime set forth in section 1503(d) of the Code and the regulations thereunder. The Treasury specifically disavowed the notion that they were attacking the double deduction or the international arbitrage advantage, but acknowledged that a review of the dual consolidated loss rules might be appropriate. Instead, the Treasury felt the abuse being challenged was the inappropriate use of the treaty benefits for interest. In the Treasury’s view, double tax treaties are meant to avoid double taxation and assume, therefore, that income flowing to the foreign jurisdiction, is subject to tax in the hands of the recipient. If such income is not subject to foreign tax, then the taxpayer has set up a structure, which eliminates U.S. tax on untaxed income, an unintended application of the Tax Treaty.
As a result of the Treasury’s philosophical approach to domestic reverse hybrids, they specifically and deliberately left untouched an opportunity to continue inbound double deductions. When a foreign corporation establishes a DRH and checks the box in the manner described above and then borrows money through such partnership guaranteed by the parent company, no cross-border payment occurs and no treaty abuse is presented. The DRH is entitled to deduct payments to a bank under guaranteed debt fully to the extent not subject to the earnings stripping limitations of section 163(j). Assuming the DRH is transparent in the foreign jurisdiction, the foreign interest owners will be treated as receiving excludible dividends and having paid interest, just as in the case of the abuse being attacked by the regulations. While the regulations set forth certain anti-abuse rules for transactions intended to avoid the new regulations, it is relatively clear that guaranteed debt is not subject to the new rules since this structure was specifically mentioned to the Treasury and no language change resulted. Potentially also escaping the new rules are structures where the domestic reverse hybrid owns only branches, disregarded LLCs or partnerships. Distributing from such entities may not be dividends to the domestic reverse hybrid under U.S. or foreign law, but only branch distributions and would not, therefore, be subject to the new rules.
While the new reverse hybrid rules will require some modest restructuring for prior foreign ownership structures of U.S. companies to preserve the intended benefits, it is surprising that the Treasury left available the double deduction opportunity that the structure creates. By narrowing the scope of the abuse to treaty abuse, the new rule is true to its statutory authority but leaves unchallenged a benefit available only to foreign acquirers.
