Treatment of hybrid arrangements under Subpart F.

• Author: Josephs, Stuart R.
• Position: IRC Subpart F

The Treasury Department and the IRS understand that certain taxpayers are using arrangements involving "hybrid branches" to circumvent the purposes of Subpart F (Secs. 951-964). These arrangements generally involve the use of deductible payments to reduce the taxable income of a controlled foreign corporation (CFC) under foreign law, thereby reducing the CFC's foreign tax and, also under foreign law, correspondingly creating in another entity low-taxed, passive income of the type to which Subpart F was intended to apply. However, because of the structure of these arrangements, this income is not taxed under Subpart F.

The recent "check-the-box" regulations, Regs. Secs. 301.7701-1-3, have facilitated the creation of the hybrid branches used in these arrangements. In the preamble to these regulations, the Treasury and the Service said it would be monitoring the use of partnerships in the international context, since there was a concern that fiscally transparent entities could be used in a manner inconsistent with the policies and rules of particular Code provisions.

The Treasury and the IRS have concluded that the use of certain hybrid-branch arrangements, such as the ones illustrated below, is contrary to Subpart F's policies and rules. Notice 98-11 announced that the Treasury and the Service will issue regulations to address such arrangements and requested public comments on these Subpart F issues. The notice does not specify a deadline for these comments.

Background

Subpart F limits deferral of U.S. tax on certain income earned outside the U.S. by CFCs. Limited deferral was retained after Subpart F's enactment to protect the competitiveness of CFCs doing business overseas. This limited deferral allows a CFC, engaged in an active business and located in a foreign country for appropriate economic reasons, to compete in a similar tax environment with non-U.S. owned corporations located in the same country.

However, under Subpart F, transactions of CFCs that involve related persons frequently give rise to Subpart F income, unless an exception applies. Related-person transactions can be more easily manipulated to reduce both U.S. and foreign taxes. One of Subpart F's purposes is to prevent CFCs (including those engaged in active businesses) from structuring transactions designed to manipulate the inconsistencies between foreign tax systems to inappropriately generate low- or nontaxed income on which U.S. tax might be permanently deferred.

U.S...