New hybrid legislation and regulations affecting treaty planning.

• Author: Gordon, Richard A.
• Position: Hybrid structured business entities

On June 30, 1997, the IRS issued temporary and proposed regulations under Sec. 894, relating to payments to flow-through entities. Temp. Regs. Sec. 1.894-1T(d)(1) limits a foreign person's ability to claim a treaty-reduced withholding rate when amounts are paid by a U.S. person to the foreign person via a "hybrid entity" (whether U.S. or foreign). The regulations are effective for payments made after 1997. The preamble states that the "IRS does not intend to challenge any claim of treaty benefits for payments made before the effective date of these regulations on the basis that the claim was based on principles inconsistent with those upon which these regulations are based."

Section 1054 of the Taxpayer Relief Act of 1997 (TRA '97) (enacted Aug. 5, 1997) added Sec. 894(c) to the Code. That subsection has two elements: a legislative rule immediately denying treaty benefits in certain cases and a grant of regulatory authority to deny treaty benefits in cases not covered by the new rule. The TRA '97 Conference Report states that the temporary regulations are consistent with the provision in the Conference Agreement and with U.S. treaty obligations.

In Example 1, Canadian corporation owns a U.S. limited liability company (LLC), which is treated as a corporation for Canadian tax purposes and as a branch for U.S. tax purposes. Before the TRA '97, an interest payment to the LLC from the U.S. corporation was eligible for a reduced rate of withholding tax (10%, instead of 30%) because of the tax treaty between the U.S. and Canada. The payment of the interest created a deduction on the US. corporation's return. However, the interest income was not taxable in Canada because it was considered income of a U.S. corporation. A distribution of the earnings of the U.S. LLC to the Canadian corporation was not subject to tax in Canada, because Canada treated the income as a tax-exempt dividend. The U.S. reduced its withholding tax when there was no taxation in Canada. Since the principal purpose of tax treaties is to provide relief from double taxation, the TRA '97 denies treaty benefits in this case because there is no tax by Canada and, therefore, no double taxation.

[Example 1 ILLUSTRATION OMITTED]

Sec. 894(c)

Sec. 894(c) provides that a foreign person shall not be entitled under any income tax treaty of the United States with a foreign country to any reduced rate of withholding tax imposed by this title on an item of income derived through an entity that...