Regulations issued for Notice 98-11.

• Author: Raedel, John
• Position: IRS notice

On Jan. 16, 1998, the IRS issued Notice 98-11, announcing that regulations would be issued to treat a controlled foreign corporation (CFC) and its "hybrid branch" as separate corporations for purposes of subpart F, in the case of certain, arrangements designed "to circumvent the purposes of Subpart F, (Notice 98-11 was discussed in the May 1098 Tax Clinic article, "Treatment of Hybrid Arrangements Under Subpart F.") On March 23,1998, the Service, delivered on this promise by issuing temporary and final subpart F regulations (TD 8767) on hybrid entity arrangements.

The new regulations address two examples cited in Notice 98-11 as purportedly abusive hybrid entity arrangements. In Example 1, a CFC sought the "same-country" exception on its payment of interest to a hybrid branch of a related same-country CFC. In Example 2, a CFC pays interest to its own hybrid branch. In both examples, the CFC paying the interest reduces its foreign tax and seeks to avoid generating a corresponding amount of subpart F income for inclusion in the U.S. shareholder's gross income. Temp. Regs. Sec. 1.954-9T approaches this area by first creating a generally uniform set of concepts that must be present before the new rules will apply:

* Inconsistent tax treatment of entities: There must be some inconsistency in the fiscal transparency, or lack thereof, between U.S. and foreign law, of an entity. Temp. Regs. Sec. 1.954-9T(a)(7) provides a definition of fiscal transparency more detailed than that provided by Notice 98-11.

* Foreign income tax reduction: The payment must either reduce the foreign income tax of the payor or an owner of the payor, or generate a tax attribute that may be carried over to reduce the foreign income tax of the payor or owner in another year (Temp. Regs. Sec. 1.954-9T(a)(1) and (3)).

* Disparity between foreign effective tax rates: There must be a sufficient disparity in the income tax rates of the payor and the payee of the payment. To constitute a sufficient disparity, the payment must be taxed in the year when earned at an effective rate of tax that is less than 90% of, and at least five percentage points less than, the "hypothetical" effective tax rate imposed on the payment. The hypothetical effective rate depends on the tax rates that would have applied to the payor (Temp. Regs. Sec. 1.954-9T(a)(5)(iv)).

The regulations create three new rules, each of which is triggered by meeting these inconsistency, tax disparity and foreign tax...