International Tax Institute HYBRIDS International Tax Institute May 15, 2018 Michael Steinsaltz - Partner, Deloitte Tax LLP Brian Krause - Partner, Skadden, Arps, Slate, Meagher & Flom LLP John Merrick - Senior Level Counsel to Associate Chief Counsel/IRS Office of Associate Chief Counsel (International)

Agenda Background on Hybrid Mismatch Rules Hybrid Dividends – 245A(e) Hybrid Transactions and Hybrid Entities

Background on Hybrid Mismatch Rules

BEPS and UK/EU Rules The 2015 Final Report on Action 2, Neutralising the Effects of Hybrid Mismatch Arrangements (“Action 2”), addresses concerns that “hybrid mismatch arrangements exploit differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral.” Action 2 provides recommendations which are designed to neutralize hybrid mismatch arrangements. Action 2 defines a “hybrid mismatch arrangement” as a payment made by or to a hybrid entity that gives rise to one of the following types of mismatches in tax treatment between countries: deduction/no inclusion (D/NI) outcomes, where the payment is deductible under the rules of the payer jurisdiction but not included in the ordinary income of the payee; double deduction (DD) outcomes, where the payment triggers two deductions in respect of the same payment; or indirect deduction/no inclusion (indirect D/NI) outcomes, where the income from a deductible payment is set off by the payee against a deduction under a hybrid mismatch arrangement

BEPS and UK/EU Rules Subsequent to the issuance of Action 2: the UK issued anti-hybrid legislation effective January 1, 2017 the EU issued its anti-tax avoidance directive (ATAD) mandating intra-EU anti-hybrid legislation as of January 1, 2019 and ATAD II mandating inter-EU anti-hybrid legislation (and expanding the scope of ATAD to include indirect mismatch rules) effective January 1, 2020

Section 245A(e) Consistent with the European Commission’s Anti-Tax Avoidance Directives and consistent with a recommendation of the BEPS Project’s Action 2, Section 245A does not allow the DRD for a dividend with respect to which the payer receives a deduction (or other tax benefit) from taxes imposed by a foreign country (a “hybrid dividend”). No FTC or deduction is allowed for any taxes paid or accrued (or treated as paid or accrued) with respect to any hybrid dividend received by a U.S. shareholder or included in the U.S. shareholder’s income. A hybrid dividend received by a US shareholder’s CFC from another CFC of the same shareholder is treated as subpart F income of the CFC. The Secretary is authorized to issue regulations or other guidance that is necessary or appropriate to carry out these provisions.

Section 267A IRC Section 267A The provision denies a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. A disqualified related party amount is any interest or royalty paid or accrued to a related party to the extent that: (1) there is no corresponding inclusion to the related party under the tax law of the country of which such related party is a resident for tax purposes or is subject to tax, or (2) such related party is allowed a deduction with respect to such amount under the tax law of such country. A disqualified related party amount does not include any payment to the extent such payment is included in the gross income of a U.S. shareholder under section 951(a).

Section 267A IRC Section 267A HYBRID TRANSACTION.—For purposes of this section, the term hybrid transaction’ means any transaction, series of transactions, agreement, or instrument one or more payments with respect to which are treated as interest or royalties for purposes of this chapter and which are not so treated for purposes the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax.   HYBRID ENTITY.—For purposes of this section, the term ‘hybrid entity’ means any entity which is either— treated as fiscally transparent for purposes of this chapter but not so treated for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax, or (2) treated as fiscally transparent for purposes of such tax law but not so treated for purposes of this chapter.

Policy Considerations How should we look at sections 245A(e) and 267A in comparison to BEPS Action 2, the UK anti-hybrid rules, and ATAD II? Why was 267A drafted so differently considering the roadmap that already existed? How should taxpayers think about guidance as being prospective or retroactive? What considerations go into this decision? How would the rules interact w/other countries’ hybrid mismatch rules (consider ATAD implementation) and the lack of a “secondary” US rule? CFC regimes? Consider the subpart income F exception, regulatory authority, and guidance under BEPS Action 2.  

Hybrid Dividends

Country X: Interest Accrual Section 245A Timing Differences Between Interest and Dividends; Effect of PTI What if in year 1 interest is accrued (but not paid) for Country X purposes and no dividends are paid for U.S. purposes? What if X CFC has PTI? What if the deduction in Country X does not completely eliminate Country X tax? Should the US care about the hybrid nature of the dividend given the CFC’s income is subject to the GILTI tax? Does the denial of credits for withholding tax on 245A(e) sense as a matter of policy? US Co + Year 1: Country X: Interest Accrual US: Nothing Hybrid Inst. X CFC _

Section 245A Scope of Hybrid Dividend Definition What is the scope of “(or other tax benefit)” in section 245A(e)(4)(B)? What if Country X allows notional interest deductions on equity? US Co X CFC

Section 245A Tiered Hybrid Dividends Involving CFCs US Co US Co + + How 245A(e)(4)(A) is applied in the “tiered” (or foreign-to-foreign) hybrid dividend context. That is, can a CFC claim a 245A DRD? See FN 1486 in conference report. US Co US Co 100% 100% + X CFC + X CFC Hybrid Inst. 100% Hybrid Inst. 10% Y CFC Y F Co _ _

Hybrid Transactions and Hybrid Entities

§267A(d)(2) Definition of Hybrid Entity Section 267A(d)(2) defines a hybrid entity as an entity treated as fiscally transparent for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax, but not so treated for U.S. tax purposes Does this definition work? Should the definition look to country of organization rather than residence since reverse hybrids are typically not tax resident in any country? Does US perspective makes sense in all cases or should investor country perspective be determinative? A Co B Co C Co Interest or Royalty

Preferential Rate for Royalties Connection Between Hybridity and No Inclusion What if all countries view as a license/royalty? Conference report discusses disallowing deductions where hybrid nature is what causes application of preferential regime What if, instead, US Co paid the royalty directly (not through Z Co DE)? Preferential Rate for Royalties + Y Co Non-hybrid license US Co Royalty Z Co _

Section 267A Application to Foreign Payors USP FP USP Interest or Royalty USP CFC1 CFC2 CFC1 CFC2 Interest or Royalty Interest or Royalty DRE CFC1

What if Payee Country Does Not Impose Any Tax? Does the lack of any tax imposed on the hybrid payment result in “no inclusion” by the related party under the tax laws of the jurisdiction in which it is resident? A Co US FDE C Co (0% Tax) Interest or Royalty

Can the U.S. be the “No Inclusion” Jurisdiction? USP If royalty is eligible for FDII deduction, does the 250A deduction turn the payment into a “disqualified related party amount” in whole or in part? USP Does USS’s deduction make USP’s income “no inclusion” income? Definition of related person Consider consolidated return regulation matching rule + CFC 1 USS Royalty Royalty CFC 2 Z Co _ _

§267A Conduit Arrangements What if Country Y and Country X have not adopted hybrid mismatch rules? Regulatory grant of authority to address conduit arrangements under section 267A(e)(1) Y Co + $100 Hybrid Inst. US Co X Co _ $100 _ + Debt Inst. (Non-Hybrid)

Effect on E&P? What is the effect of interest expense that is disallowed under section 267A on earnings and profits? FP + Hybrid Inst. USS _

Regulatory Authority

267A Anti-Hybrid Provisions Regulatory Authority 267A provides for authority to issue regulations: denying deductions for conduit arrangements that involve a hybrid transaction or a hybrid entity, the application of this provision to branches and domestic entities applying this provision to certain structured transactions denying all or a portion of a deduction claimed for an interest or a royalty payment that, as a result of the hybrid transaction or entity, is included in the recipient’s income under a preferential tax regime of the country of residence of the recipient and has the effect of reducing the country’s generally applicable statutory tax rate by at least 25 percent denying all of a deduction claimed for an interest or a royalty payment if such amount is subject to a participation exemption system or other system which provides for the exclusion or deduction of a substantial portion of such amount, rules for determining the tax residence of a foreign entity if the foreign entity is otherwise considered a resident of more than one country or of no country exceptions to the general rule set forth in the provision, and requirements for record keeping, and information in addition to any requirements imposed by section 6038A.

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