Foreign notional interest regimes may hinder deductions of US subsidiaries.

• Author: Stuardi, Pietro

The recently enacted U.S. anti-avoidance tax rules targeting hybrid mismatches undoubtedly cast a very wide net. The application of these rules poses substantial challenges for global businesses and international tax practitioners, especially where the arrangements carrying the "hallmarks" of hybridity (e.g., instruments treated as debt in one country and equity in the other, or entities treated as taxpaying corporations in one tax jurisdiction and fiscally transparent in another) are not present or are far removed from the U.S. taxpayer whose deductions are at stake. In this context, it may come as a surprise how seemingly benign inbound structures involving interest or royalty payments by U.S. subsidiaries to foreign affiliates may trigger these anti-avoidance rules where the foreign affiliates operate in countries that have notional interest deduction (NID) tax regimes.

US hybrid mismatch rules affecting inbound structures

By way of background, the law known as the Tax Cuts and Jobs Act, P.L. 115-97, added Secs. 245A(e) and 267A (this discussion does not address the potential application of Sec. 245A(e) to NIDs), which deny a dividends-received deduction for certain hybrid dividends and deny deductions for certain hybrid arrangements, respectively. The principles in these provisions and final Treasury regulations issued in April 2020 (T.D. 9896) are, other than a germane difference described below, generally similar to the hybrid mismatch rules in the Organisation for Economic Co-operation and Development's base-erosion and profitshifting (BEPS) Action 2, Neutralising the Effects of Branch Mismatch Arrangements.

Sec. 267A, very broadly, denies a deduction to a U.S. taxpayer for payment or accrual of interest or royalties to a foreign person where there is no corresponding income inclusion for the payee under foreign tax law as a result of a hybrid arrangement (hereinafter referred to as a "hybrid deduction"). A common inbound structure targeted by these rules may involve a U.S. subsidiary making interest payments to its foreign parent under the terms of an instrument characterized as debt for U.S. federal income tax purposes but treated as equity under the tax laws of the parent's jurisdiction. In this scenario, absent the operation of Sec. 267A, the U.S. company could avail itself of an interest deduction while the foreign parent might be able to avoid the recognition of taxable income for local tax purposes under a participation...