Hybrid financing structures.

• Author: Judice, Curtis K.

Over the years, hybrid financing structures (Structures) have attracted scrutiny from the IRS and Treasury. Structures generally use a combination of hybrid entities and hybrid notes to achieve a "double dip"--i.e., a deduction in two different taxing jurisdictions on the same loan, through intercompany financing arrangements.

Certain entities and notes are considered hybrid based on differences in law of two taxing jurisdictions. For example, an entity may be treated as a corporation for foreign tax purposes and disregarded for U.S. tax purposes. Similarly, an intercompany financing arrangement may be treated as debt for foreign tax purposes and as a capital contribution for U.S. tax purposes. The Service and Treasury have responded to these Structures through a series of administrative rulings and regulations.

Attorney Memorandum 2006-001

In September 2006, the IRS Office of Chief Counsel issued Attorney Memorandum (AM) 2006-001, in which P, a U.S. corporation, wholly owns a foreign disregarded entity (DE) and a controlled foreign corporation (CFC). DE is disregarded for U.S. tax purposes and treated as a corporation for foreign tax purposes. DE and CFC both are organized in Country X (i.e., a country other than the U.S.).

DE borrows from an unrelated third party and lends the cash proceeds to CFC in exchange for a promissory note (note). Simultaneously, P enters into a forward purchase agreement with CFC, in which P will buy CFC stock for the same amount as the note's principal payment. The forward purchase agreement's payment terms are tailored to match the note's payment terms. Interest payments on the note will be paid in CFC stock; see the exhibit above for a diagram of the Structure. The IRS concludes that, for

U.S. tax purposes, the ... note and the forward purchase agreement should be considered together with the result that they are not treated as debt. Accordingly, for U.S. tax purposes, P is not required to report the periodic payments with respect to the ... note as interest income.

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Analysis and Observations

In AM 2006-001, P could take an interest expense deduction for DE's loan because DE was disregarded (rather than being treated as a foreign corporation) under Regs. Sec. 301.7701 -2(a) and -3. In other words, the U.S. treats P and DE as a single entity in which all of DE's activities are taken into account by P (applying U.S. tax law). Under foreign tax law, DE is treated as a corporation (i.e., a...