Sec. 894 final rules for recharacterizing deductible payments.

• Author: Sair, Edward A.

Sec. 894 final regulations address payments made by domestic reverse hybrid entities (DRHs). In certain cases, these regulations can characterize deductible payments that a DRH makes to a related foreign interest holder (RFIH) as nondeductible dividend payments. They are effective for payments that the DRH makes or receives after June 11,2002.

Targeted Transactions

According to Regs. Sec. 1.894-1(d) (2)(ii)(B), the new recharacterization rules apply when:

1. A domestic entity makes a payment to a DRH that is treated as a dividend under either U.S. law or the laws of an RFIH's jurisdiction;

2. The laws of the RFIH's jurisdiction require it to separately account for its share of the payment to the DRH, on a current basis, whether or not distributed (see Regs. Sec. 1.894-1 (d)(3)(iii));

3. The DRH makes a payment deductible for U.S. tax purposes to either:

   (a) the RFIH or

   (b) a person (wherever organized) whose income and losses are available under the law of the RFIH's jurisdiction, to offset those of the RFIH (i.e., a member of the DRH's consolidated group or some other entity eligible for group relief or other offset against the RFIH's income and losses); and

4. The deductible payment is eligible for a reduced withholding tax rate under an income tax treaty.

   When applicable, Regs. Sec. 1.894-1 (d)(2)(ii)(B)(1)(iii) will recharacterize all or a portion of an otherwise deductible payment as a Sec. 301(a) distribution, for all purposes of the Code and any income tax treaty. As a result, the DRH will lose the benefit of the deduction (or a portion thereof); the recharacterized payment will be subject to the withholding rate on dividends, rather than the rate on interest or royalties, even if the dividend withholding rate is less than the interest rate (e.g., under the U.S.-Canada treaty). The appropriate withholding rate on amounts recharacterized as dividends is determined under the treaty between the RFIH's home country and the U.S., even if the payment is actually made to a person described in 3.(b) above (e.g., a sister company), located in another jurisdiction.

   Definition of Related Person

   The recharacterization rules do not apply unless a U.S. entity makes a payment to a related DRH and the DRH makes a payment to either an RFIH or another person whose income and losses combine with the RFIH's, under the RFIH's tax jurisdiction.

   A person is related to a DRH under Regs. Sec. 1.894-1(d)(2)(ii)(B)(4) if he or she meets the Sec. 267(b) or...