On July 9, 1999, the Treasury issued proposed regulations that withdrew Notice 98-35 and imposed at least a six-year moratorium on hybrid branch regulations. Notice 98-35 was issued in June 1998 to announce the Service's plans to withdraw temporary and proposed regulations on the use of controlled foreign corporations (CFCs) and hybrid branches under subpart F. Notice 98-11, which announced the IRS'S intent to issue those regulations, was also withdrawn at that time.
Notice 98-35 was issued in response to opposition from Congress, taxpayers and practitioners to the proposed and temporary regulations. It indicated that the Service intended to issue a new notice of proposed rulemaking covering CFCs, hybrid transactions and subpart F income. The IRS did not plan to finalize the regulations before Jan. 1, 2000, but they would be effective for all payments made under hybrid arrangements on or after June 19, 1998, unless otherwise specified. Permanent relief was provided for any payments made under hybrid arrangements entered into before June 19, 1998, as long as the arrangement was not substantially modified after that date.
A hybrid branch is one that is viewed to be part of a CFC for U.S. income tax purposes, but is treated as a separate entity under the laws of the foreign jurisdiction in which it is organized. Notice 98-11 identified arrangements that the Service defined as contrary to the policies and rules of subpart E These arrangements involve the use of deductible payments from the CFC to the hybrid branch, thereby reducing the CFC'S taxable income and foreign income tax. The hybrid branch is created in a low-tax jurisdiction; therefore, the corresponding income recognition is taxed at a lower rate than the payor is subject to. As a result, total foreign income taxes are reduced. The income of the hybrid branch is passive income to which the IRS believes the subpart F rules were intended to apply; however, because of the structure of the arrangement, this income would not otherwise be taxed under subpart F.
With the exception of the effective date of the regulations, the new proposed regulations are substantially the same as the proposed and temporary regulations issued in 1998. Under the new proposed regulations, certain payments made between a CFC and its hybrid branch (or between hybrid branches of the CFC) may give rise to subpart F income. The new rules apply to "hybrid branch payments," defined as payments made between two...