This information is based on the statutes and guidance available as of the date of publication and is subject to change. 

The Tax Cuts and Jobs Act, effective for tax years beginning after 12/31/2017, disallows U.S. tax deductions for interest and royalties paid or accrued to a related party in a hybrid transaction, or to a hybrid entity.

It is important to note that the provisions as drafted may apply to interest and royalty payments in common “check the box” structures, including for example, interest payments to a related GmbH & Co. KG treated as a corporation for U.S. tax purposes. The statute gives the Secretary of the Treasury broad authority to issue regulations that provide exceptions for situations in which taxation is not avoided. However, until regulations are issued, there is no assurance that any exceptions will be available.

Consequently, all structures that include a hybrid entity or hybrid financial instrument should be reviewed as soon as possible.

 

Summary

The new Internal Revenue Code Section 267A disallows deductions for interest and royalty payments to a disqualified related party pursuant to a hybrid transaction, or by, or to, a hybrid entity.

A hybrid transaction is generally any transaction in which payments treated as interest or royalties for U.S. tax purposes are not so treated for purposes of the tax law of the recipient’s foreign country. For example, interest payments that are considered dividends for foreign tax purposes.

A hybrid entity is an entity that is treated as fiscally transparent in the U.S., but not for purposes of the tax law of a foreign country, or vice versa.

A disqualified related party payment is any interest or royalty paid or accrued to the extent that the payment:

Is not included in the income of the related foreign party under the tax law of the country in which the related party is resident or subject to tax; or

The related party is allowed a deduction with respect to the amount under the tax law of the foreign country

A person is considered related to the person making the disqualified payment if:

That person is an individual, corporation, partnership, trust, or estate which controls, or is controlled by, the person making the payment of the disqualified related party amount; or 

That person is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the person making the payment of the disqualified related party amount

The term control for these purposes means more than 50% ownership. This ownership can be direct, indirect or by attribution.

Future Guidance and Actions to Consider Now

As noted above, the Secretary of the Treasury is directed to issue regulations necessary to carry out the purpose of the new Section. Specifically, the Secretary of Treasury has been instructed to issue regulations that address anti-conduit and anti-avoidance rules, rules applying the limitation to foreign branches or domestic entities, treating a foreign “preference” that reduces tax by 25% or more as an exclusion, application of the rules to systems such as a participation exemption regime, rules for determining country of residence where there are multiple or no apparent residences, and requirements for record keeping.  

The Secretary has also been instructed to include in the regulations potential exceptions for cases in which the recipient of the income is subject to tax in a country other than the country of residence, and in other cases where it is determined that the arrangements do not risk eroding the Federal tax base. 

It is possible under the general authority to grant an exemption that the regulations will provide relief for situations in which the income is ultimately subject to tax in the recipient’s country of tax residence. For example, where related party interest is earned by a “check the box” GmbH & Co. KG owned by German residents. However, there is no assurance that such relief will be forthcoming. Accordingly, in all cases where interest or royalties are paid in hybrid transactions or to or by hybrid entities as defined in the statute, the impact of the limitation should be reviewed and remedial action considered.