Hybrid entities and treaty benefits.

• Author: O'Connell, Frank J., Jr.
• Position: U.S. income tax treaties

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...