[Federal Register Volume 63, Number 58 (Thursday, March 26, 1998)]
[Rules and Regulations]
[Pages 14613-14620]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-7891]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[TD 8767]
RIN 1545-AWO7


Guidance Under Subpart F Relating to Partnerships and Branches

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary and final regulations.

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SUMMARY: This document contains regulations relating to the treatment 
under subpart F of certain payments involving branches of a controlled 
foreign corporation (CFC) that are treated as separate entities for 
foreign tax purposes or partnerships in which CFCs are partners. These 
regulations are necessary to provide guidance on transactions relating 
to such entities. These regulations will affect United States 
shareholders of controlled foreign corporations. The text of these 
temporary regulations also serves as the text of the proposed 
regulations published elsewhere in this issue of the Federal Register.

DATES: Effective date: These regulations are effective March 23, 1998.
    Applicability date: For dates of applicability see Secs. 1.904-
5T(o), 1.954-1T(c)(1)(i)(E), 1.954-2T(a)(5)(iii) and (a)(6)(ii), 1.954-
9T(d) and 301.7701-3T(f) of these regulations.

FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

I. In General

    In these temporary regulations and in proposed regulations 
published elsewhere in this issue of the Federal Register, the Treasury 
and IRS set forth a framework for dealing with issues posed by the use 
of certain entities that are regarded as fiscally transparent for 
purposes of U.S. tax law, with regard to the application of subpart F 
of the Internal Revenue Code.
    Subpart F was enacted by Congress to limit the deferral of U.S. 
taxation of certain income earned outside the United States by foreign 
corporations controlled by U.S. persons. Limited deferral was retained 
after the enactment of subpart F to protect the competitiveness of 
controlled foreign corporations (CFCs) doing business overseas. See S. 
Rep. No. 1881, 87th Cong., 2d Sess. 78-80 (1962). This limited deferral 
furthers the objective of allowing 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.
    Conversely, one of the purposes of subpart F is to prevent CFCs 
from converting active income that is not easily moveable and is earned 
in a jurisdiction in which a business is located for non-tax reasons, 
into passive, easily moveable income that is shifted to a lower tax 
jurisdiction primarily for tax avoidance. Moreover, when subpart F was 
first enacted it was realized that related person transactions can be 
easily manipulated to reduce both United States and foreign taxes. 
Consequently, in enacting subpart F, Congress provided that 
transactions of CFCs that involve related persons generally give rise 
to subpart F income with certain enumerated exceptions.
    Hybrid branches, which, by definition, are not regarded as fiscally 
transparent under foreign law, are particularly well suited to the type 
of tax avoidance described above. In light of the recent proliferation 
of hybrid branches, Treasury and the IRS believe that it is appropriate 
to consider the issues related to transactions involving hybrid 
branches, or other hybrid entities, under subpart F.
    The use of partnerships that are fiscally transparent for U.S. tax 
purposes raises additional issues in the context of subpart F that are 
similar to those raised in connection with hybrid branches. Such 
partnerships may or may not be fiscally transparent under foreign law. 
(Other fiscally-transparent entities, such as grantor trusts, will be 
the subject of guidance issued in conjunction with the finalization of 
regulations under section 672(f).)
    The entity classification regulations of Secs. 301.7701-1 through 
301.7701-3 (the check-the-box regulations) make entity classification 
generally elective, in part so that taxpayers can choose a tax status 
that is consistent with their business objectives. This administrative 
provision was not intended to change substantive law. Particularly in 
the international area, the ability to more easily achieve fiscal 
transparency can lead to inappropriate results under certain 
substantive international provisions of the Code. Thus, the Treasury 
and the IRS believe that it is necessary to provide additional guidance 
regarding the use of hybrid entities in the international context. See

[[Page 14614]]

preamble to TD 8697, 61 FR 66585 (December 18, 1996).

II. Hybrid Branches

    As announced in Notice 98-11 (1998-6 I.R.B. 13), the Treasury and 
the IRS understand that certain taxpayers are using arrangements 
involving hybrid branches to circumvent the purposes of subpart F 
(sections 951 through 964 of the Code). These arrangements generally 
involve the use of deductible payments to reduce the taxable income of 
a CFC under foreign law, thereby reducing that CFC's foreign tax and, 
also under foreign law, the corresponding creation in another entity of 
low-taxed, passive income of the type to which subpart F was intended 
to apply. Because of the structure of these arrangements, however, 
taxpayers take the position that this income is not taxed under subpart 
F. Treasury and the IRS have concluded that use of these hybrid branch 
arrangements is contrary to the policies and rules of subpart F.
    U.S. international tax policy seeks to balance the objective of 
neutrality of taxation between domestic and foreign business 
enterprises (seeking neither to encourage nor to discourage one over 
the other), while keeping U.S. business competitive. Subpart F strongly 
reflects and enforces that balance, while the arrangements described 
above involving hybrid branches upset that balance.

Explanation of Provisions

    Under these temporary regulations, hybrid branch payments, as 
defined in the regulations, between a CFC and its hybrid branch, or 
between hybrid branches of the CFC may give rise to subpart F income. 
When certain conditions are present, the non-subpart F income of the 
CFC, in the amount of the hybrid branch payment, is recharacterized as 
subpart F income of the CFC. Those conditions include that: the hybrid 
branch payment reduces the foreign tax of the payor; the hybrid branch 
payment would have been foreign personal holding company income if made 
between separate CFCs; and there is a disparity between the effective 
rate of tax on the payment in the hands of the payee and the 
hypothetical rate of tax that would have applied if the income had been 
taxed in the hands of the payor. Treasury and the IRS are considering 
applying similar principles with respect to the foreign base company 
services income rules of section 954(e). Comments are requested on this 
issue. Any regulations promulgated on this issue will be prospective.
    Policies underlying subpart F would also be avoided in certain non-
hybrid branch transactions that do not reduce the tax of the payor. 
Treasury and the IRS invite comments on the extent to which rules 
should be provided to address such transactions. Any regulations 
promulgated on this issue will be prospective. Comments are also 
requested regarding the application of these rules to dividend and 
other equity distributions.
    The temporary regulations make clear that the CFC and the hybrid 
branch, or the hybrid branches, are treated as separate corporations 
only to recharacterize non-subpart F income as subpart F income in the 
amount of the hybrid branch payment, and to apply the tax disparity 
rule of Sec. 1.954-9T(a)(5)(iv). For all other purposes (e.g., for 
purposes of the earnings and profits limitation of section 952), a CFC 
and its hybrid branch, or hybrid branches, are not treated as separate 
corporations.
    The temporary regulations provide that the amount recharacterized 
as subpart F income is the gross amount of the hybrid branch payment 
limited by the amount of the CFC's earnings and profits attributable to 
non-subpart F income. This amount is the excess of current earnings and 
profits over subpart F income, determined after the application of the 
rules of sections 954(b) and 952(c) and before the application of these 
temporary regulations. To the extent that the full amount required to 
be recharacterized under this provision cannot be recharacterized 
because it exceeds earnings and profits attributable to non-subpart F 
income, there is no requirement to carry such amounts back or forward 
to another year.
    For purposes of determining the amount of taxes deemed paid under 
section 960, the amount of non-subpart F income recharacterized as 
subpart F income is treated as attributable to income in separate 
foreign tax credit baskets in proportion to the ratio of non-subpart F 
income in each basket to the total amount of non-subpart F income of 
the CFC for the taxable year.
    The temporary regulations provide that, under certain 
circumstances, the recharacterization rules will also apply to a CFC s 
proportionate share of any hybrid branch payment made between a 
partnership in which the CFC is a partner and a hybrid branch of the 
partnership, or between hybrid branches of such a partnership. When the 
partnership is treated as fiscally transparent by the CFC's taxing 
jurisdiction, the recharacterization rules are applied by treating the 
hybrid branch payment as if it had been made directly between the CFC 
and the hybrid branch, or as though the hybrid branches of the 
partnership had been hybrid branches of the CFC, as applicable. If the 
partnership is treated as a separate entity by the CFC's taxing 
jurisdiction, the recharacterization rules are applied to the 
partnership as if it were a CFC. Comments are requested on whether the 
rule for such non-fiscally transparent partnerships should be relaxed 
in the case of small ownership interests.
    The temporary regulations provide that income will not be 
recharacterized unless there is a disparity between the effective rate 
at which the hybrid branch payment is taxed to the payee and a 
hypothetical tax rate that measures the tax savings to the payor from 
the deductible payment. This provision is similar to the rule in 
Sec. 1.954-3(b), and adopts the same percentage tests as contained in 
that provision. The regulations also provide a special high tax 
exception applicable to the hybrid branch payment that is similar to 
the one contained in section 954(b)(4). Comments are invited on whether 
the rules of Sec. 1.954-9T could cause inappropriate multiple 
recharacterizations where the hybrid branch payments are made through a 
series of related hybrid entities.
    The temporary regulations provide that if these provisions affect 
an entity that has elected under Sec. 301.7701-3(c) to be treated as an 
entity disregarded as separate from its owner, such an entity may elect 
to be classified as a corporation, provided it fulfills certain 
requirements, notwithstanding the sixty-month limitation in that 
section.

III. Related Provisions

    These temporary regulations provide rules, contained in Sec. 1.954-
1T(c)(1)(i)(B), to prevent expenses, including related person interest 
expense which would normally be allocable under section 954(b)(5) to 
subpart F income of a CFC, from being allocated to a payment from which 
the expense arises. The allocation limit applies: (i) to the extent 
such payment is included in the subpart F income of the CFC; (ii) if 
the expense arises from any payment by the CFC to a hybrid partnership 
in which the CFC is a partner; and (iii) if the payment reduces foreign 
tax and there is a significant disparity in tax rates between the payor 
and payee jurisdictions.
    These temporary regulations also address the application of the 
related person exceptions to the foreign personal holding company 
income rules in the context of partnership distributive shares and 
transactions involving hybrid branches. Under section 954(c)(3), 
foreign personal

[[Page 14615]]

holding company income does not include certain interest, dividends, 
rents and royalties received from related corporations. These 
exceptions apply, in the case of interest and dividends, when the 
related corporate payor is organized in the country in which the CFC is 
organized and uses a substantial part of its assets in a trade or 
business in that country and, in the case of rents and royalties, when 
the rent or royalty payment is made for the use or privilege of using 
property within the CFC's country of incorporation.
    The rules regarding the application of the related person 
exceptions with respect to a CFC partner's distributive share of 
partnership income are part of the broader set of rules addressing 
distributive share issues in the context of subpart F contained in the 
proposed regulations published elsewhere in this issue of the Federal 
Register. Certain rules relating to the related person exception with 
respect to a CFC partner's distributive share of partnership income, 
and certain rules relating to the related person exception with respect 
to hybrid branches, however, are included in these temporary 
regulations because they address a fact pattern similar to the one to 
which the hybrid branch payment rules apply. No inference is intended 
as to the treatment under existing law of such arrangements in relation 
to the related party exceptions.
    Under these rules, if the partnership receives an item of income 
that reduces the income tax of the payor, the related person exceptions 
of section 954(c)(3) apply to exclude the income from the foreign 
personal holding company income of the CFC partner only where: the 
exception would have applied if the CFC earned the income directly 
(testing relatedness and country of incorporation at the CFC partner 
level); and either the partnership is organized and operates in the 
CFC's country of incorporation, the partnership is treated as fiscally 
transparent in the CFC's countries of incorporation and operation, or 
there is no significant disparity between the effective rate of tax 
imposed on the income and the rate of tax that would be imposed on the 
income if earned directly by the CFC partner.
    The rules applying the related person exceptions with respect to 
hybrid branches address transactions illustrated in the first example 
of Notice 98-11 (1998-6 I.R.B. 13). These rules apply to payments by a 
CFC to a hybrid branch of a related CFC. Under these rules, the related 
person exceptions will apply to exclude the payments from the foreign 
personal holding company income of the recipient CFC only if the 
payment would have qualified for the exception if the hybrid branch had 
been a separate CFC incorporated in the jurisdiction in which the 
payment is subject to tax (other than a withholding tax).

IV. Effective Date.

    These regulations are effective March 23, 1998. For dates of 
applicability see Secs. 1.904-5T(o), 1.954-1T(c)(1)(i)(E), 1.954-
2T(a)(5)(iii) and (6)(iii), 1.954-9T(d) and 301.7701-3T(f) of these 
regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedures Act (5 
U.S.C. chapter 5) does not apply to these regulations and, because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
temporary regulations will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of these regulations is Valerie Mark, of the 
Office of the Associate Chief Counsel (International). Other personnel 
from the IRS and Treasury Department also participated in the 
development of these regulations.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 301 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for 26 CFR part 1 continues to 
read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. In Sec. 1.904-5, paragraph (o) is amended by adding a 
sentence at the end to read as follows:


Sec. 1.904-5  Look-through rules as applied to controlled foreign 
corporations and other entities.

* * * * *
    (o) * * * Paragraph (k)(1) of this section does not apply on or 
after March 23, 1998. For rules applicable on or after March 23, 1998, 
see Sec. 1.904-5T(k)(1).
    Par. 3. Sec. 1.904-5T is added to read as follows:


Sec. 1.904-5T  Look-through rules as applied to controlled foreign 
corporations and other entities (temporary).

    (a) through (j) [Reserved]. For further guidance, see Sec. 1.904-
5(a) through (j).
    (k) Ordering rules--(1) In general. Income received or accrued by a 
related person to which the look-through rules apply is characterized 
before amounts included from, or paid or distributed by, that person 
and received or accrued by a related person. For purposes of 
determining the character of income received or accrued by a person 
from a related person if the payor or another related person also 
receives or accrues income from the recipient and the look-through 
rules apply to the income in all cases, the rules of paragraph (k)(2) 
of this section apply. Notwithstanding any other provision of this 
section, the principles of Sec. 1.954-1T(c)(1)(i) will apply to any 
expense subject to that subparagraph.
    (k)(2) through (n) [Reserved]. For further guidance, see 
Sec. 1.904-5(k)(2) through (n).
    (o) Effective date. Section 1.904-5T(k)(1) applies on or after 
March 23, 1998. For rules prior to March 23, 1998, see Sec. 1.904-
5(k)(1).
    Par. 4. Section 1.954-0(b) is amended by revising the paragraph 
heading and the entry for Sec. 1.954-0(b) in the list to read as 
follows:


Sec. 1.954-0  Introduction.

* * * * *
    (b) Outline of Secs. 1.954-0, 1.954-1 and 1.954-2.


Sec. 1.954-0  Introduction.

* * * * *
    (b) Outline of Secs. 1.954-0, 1.954-1, and 1.954-2.
* * * * *
    Par. 5. Section 1.954-1 is amended by adding a new paragraph 
(c)(1)(iv) to read as follows:


Sec. 1.954-1  Foreign base company income.

* * * * *
    (c) * * *
    (1) * * *
    (iv) Effective date. Paragraph (c)(1)(i) of this section does not 
apply to all

[[Page 14616]]

amounts paid or accrued on or after March 23, 1998 except for amounts 
paid or accrued pursuant to arrangements entered into before March 23, 
1998 and not substantially modified (including, for example, by 
expansion of the arrangement (whether by exercise of an option or 
otherwise) such as by an increase in the amount of or term of any 
borrowing, leasing or licensing constituting the arrangement, changes 
in direct or indirect control of any entity that is a party to the 
arrangement, or any similar measure which materially increases the tax 
benefit of the arrangement) on or after March 23, 1998. For rules 
applicable on or after March 23, 1998, see Sec. 1.954-1T(c)(1)(i).
    Par. 6. Section 1.954-1T is added to read as follows:


Sec. 1.954-1T  Foreign base company income (temporary).

    (a) through (c)(1)(i) [Reserved]. For further guidance, see 
Sec. 1.954-1(a) through (c)(1).
    (c)(1)(i) Deductions against gross foreign base company income--(A) 
In general. [Reserved]. For further guidance, see Sec. 1.954-
1(c)(1)(i).
    (B) Special rule for deductible payments to certain non-fiscally 
transparent entities. Notwithstanding any other provision of this 
section, except as provided in paragraph (c)(1)(i)(C) of this section, 
an expense (including a distributive share of any expense) that would 
otherwise be allocable under section 954(b)(5) against the subpart F 
income of a controlled foreign corporation shall not be allocated 
against subpart F income of the controlled foreign corporation 
resulting from the payment giving rise to the expense if--
    (1) Such expense arises from a payment between the controlled 
foreign corporation and a partnership in which the controlled foreign 
corporation is a partner and the partnership is not regarded as 
fiscally transparent, as defined in Sec. 1.954-9T(a)(7), by any country 
in which the controlled foreign corporation does business or has 
substantial assets; and
    (2) The payment from which the expense arises would have met the 
foreign tax reduction test of Sec. 1.954-9T(a)(3) and the tax disparity 
test of Sec. 1.954-9T(a)(5)(iv) if those provisions had been applicable 
to the payment.
    (C) Limitations. Paragraph (c)(1)(i)(B) shall not apply to the 
extent that the controlled foreign corporation partner has no income 
against which to allocate the expense, other than its distributive 
share of a payment described in paragraph (c)(1)(i)(B) of this section. 
Similarly, to the extent an expense described in paragraph (c)(1)(i)(B) 
of this section exceeds the controlled foreign corporation partner's 
distributive share of the payment from which the expense arises, such 
excess amount of the expense may reduce subpart F income (other than 
such payment) to which it is properly allocable or apportionable under 
section 954(b)(5).
    (D) Example. The following example illustrates the application of 
paragraph (c)(1)(i)(B) and (C) of this section:

    Example. CFC, a controlled foreign corporation in Country A, is 
a 70 percent partner in partnership P, located in Country B. Country 
A's tax laws do not classify P as a fiscally transparent entity. The 
rate of tax in country B is 15 percent of the tax rate in country A. 
P loans $100 to CFC at a market rate of interest. In year 1, CFC 
pays P $10 of interest on the loan. The interest payment would have 
caused the recharacterization rules of Sec. 1.954-9T to apply if the 
payment were made between the entities described in Sec. 1.954-
9T(a)(2). CFC's distributive share of P's interest income is $7, 
which is foreign personal holding company income to CFC under 
section 954(c). Under paragraph (c)(1)(i)(B) of this section, $7 of 
the $10 interest expense may not be allocated against any of CFC's 
subpart F income. However, to the extent the remaining $3 of 
interest expense is properly allocable to subpart F income of CFC 
other than its distributive share of P's interest income, this 
expense may offset such other subpart F income.

    (E) Effective date. Paragraph (c)(1)(i)(B), (C) and (D) of this 
section shall apply to all amounts paid or accrued on or after March 
23, 1998, except for amounts paid or accrued pursuant to arrangements 
entered into before March 23, 1998 and not substantially modified 
(including, for example, by expansion of the arrangement (whether by 
exercise of an option or otherwise) such as by an increase in the 
amount of or term of any borrowing, leasing or licensing constituting 
the arrangement, changes in direct or indirect control of any entity 
that is a party to the arrangement, or any similar measure which 
materially increases the tax benefit of the arrangement) on or after 
March 23, 1998. For rules applicable to amounts paid or accrued 
pursuant to arrangements entered into before March 23, 1998, see 
Sec. 1.954-1.
    (c)(1)(ii) through (f) [Reserved]. For further guidance, see 
Sec. 1.954-1(c)(1)(ii) through (f).
    Par. 7. Section 1.954-2T is added to read as follows:


Sec. 1.954-2T  Foreign personal holding company income (temporary).

    (a)(1) through (4) [Reserved]. For further guidance, see 
Sec. 1.954-2(a) through (4).
    (5) Special rules applicable to distributive share of partnership 
income--(i) Application of related person exceptions where payment 
reduces foreign tax of payor. If a partnership receives an item of 
income that reduced the foreign income tax of the payor (determined 
under the principles of Sec. 1.954-9T(a)(3)), to determine the extent 
to which a controlled foreign corporation's distributive share of such 
item of income is foreign personal holding company income, the 
exceptions contained in section 954(c)(3) shall apply only if--
    (A)(1) Any such exception would have applied to exclude the income 
from foreign personal holding company income if the controlled foreign 
corporation had earned the income directly (determined by testing, with 
reference to such controlled foreign corporation, whether an entity is 
a related person, within the meaning of section 954(d)(3), or is 
organized under the laws of, or uses property in, the foreign country 
in which the controlled foreign corporation is created or organized); 
and
    (2) The distributive share of such income is not in respect of a 
payment made by the controlled foreign corporation to the partnership; 
and
    (B)(1) The partnership is created or organized, and uses a 
substantial part of its assets in a trade or business in the country 
under the laws of which the controlled foreign corporation is created 
or organized (determined under the principles of Sec. 1.954-2(b)(4));
    (2) The partnership is regarded as fiscally transparent, as defined 
in Sec. 1.954-9T(a)(7), by all countries under the laws of which the 
controlled foreign corporation is created or organized or has 
substantial assets; or
    (3) The income is taxed in the year when earned at an effective 
rate of tax (determined under the principles of Sec. 1.954-1(d)(2)) 
that is not less than 90 percent of, and not more than five percentage 
points less than, the effective rate of tax that would have applied to 
such income under the laws of the country in which the controlled 
foreign corporation is created or organized if such income were earned 
directly by the controlled foreign corporation partner from local 
sources.
    (ii) Certain other exceptions applicable to foreign personal 
holding company income. [Reserved].
    (iii) Effective date. Paragraph (a)(5)(i) of this section shall 
apply to all amounts paid or accrued on or after March 23, 1998, except 
for amounts paid or accrued pursuant to arrangements entered into 
before March 23, 1998 and

[[Page 14617]]

not substantially modified (including, for example, by expansion of the 
arrangement (whether by exercise of an option or otherwise) such as by 
an increase in the amount of or term of any borrowing, leasing or 
licensing constituting the arrangement, changes in direct or indirect 
control of any entity that is a party to the arrangement, or any 
similar measure which materially increases the tax benefit of the 
arrangement) on or after March 23, 1998.
    (6) Special rules applicable to exceptions from foreign personal 
holding company income treatment in circumstances involving hybrid 
branches--(i) In general. In the case of a payment between a controlled 
foreign corporation (or its hybrid branch, as defined in Sec. 1.954-
9T(a)(6)) and the hybrid branch of a related controlled foreign 
corporation, the exceptions contained in section 954(c)(3) shall apply 
only if the payment would have qualified for the exception if the payor 
were a separate controlled foreign corporation created or organized in 
the jurisdiction where foreign tax is reduced and the payee were a 
separate controlled foreign corporation created or organized under the 
laws of the jurisdiction in which the payment is subject to tax (other 
than a withholding tax).
    (ii) Exception where no tax reduction or tax disparity. Paragraph 
(a)(6)(i) of this section shall not apply unless the payment would have 
met the foreign tax reduction test of Sec. 1.954-9T(a)(3) and the tax 
disparity test of Sec. 1.954-9T(a)(5)(iv) if those provisions had been 
applicable to the payment.
    (iii) Effective date. The rules of this section shall apply to all 
amounts paid or accrued on or after January 16, 1998, except for 
amounts paid or accrued pursuant to arrangements entered into before 
January 16, 1998, and not substantially modified (including, for 
example, by expansion of the arrangement (whether by exercise of an 
option or otherwise) such as by an increase in the amount of or term of 
any borrowing, leasing or licensing constituting the arrangement, 
changes in direct or indirect control of any entity that is a party to 
the arrangement, or any similar measure which materially increases the 
tax benefit of the arrangement) on or after January 16, 1998.
    (b) through (h) [Reserved]. For further guidance, see Sec. 1.954-
2(b) through (h).
    Par. 8. Section 1.954-9T is added to read as follows:


Sec. 1.954-9T  Hybrid branches (temporary).

    (a) Subpart F income arising from certain payments involving hybrid 
branches--(1) Payment causing foreign tax reduction gives rise to 
additional subpart F income. The non-subpart F income of the controlled 
foreign corporation will be recharacterized as subpart F income, to the 
extent provided in paragraph (a)(5) of this section, if--
    (i) A hybrid branch payment, as defined in paragraph (a)(6) of this 
section, is made between the entities described in paragraph (a)(2) of 
this section;
    (ii) The hybrid branch payment reduces foreign tax, as determined 
under paragraph (a)(3) of this section; and
    (iii) The hybrid branch payment is treated as falling within a 
category of foreign personal holding company income under the rules of 
paragraph (a)(4) of this section.
    (2) Hybrid branch payment between certain entities--(i) In general. 
Paragraph (a)(1) of this section shall apply to hybrid branch payments 
between--
    (A) A controlled foreign corporation and its hybrid branch;
    (B) Hybrid branches of a controlled foreign corporation;
    (C) A partnership in which a controlled foreign corporation is a 
partner (either directly or through one or more branches or other 
partnerships) and a hybrid branch of the partnership; or
    (D) Hybrid branches of a partnership in which a controlled foreign 
corporation is a partner (either directly or through one or more 
branches or other partnerships).
    (ii) Hybrid branch payment involving partnership--(A) Fiscally 
transparent partnership. To the extent of the controlled foreign 
corporation's proportionate share of a hybrid branch payment, the rules 
of paragraphs (a)(3), (4) and (5) of this section shall be applied by 
treating the hybrid branch payment between the partnership and the 
hybrid branch as if it were made directly between the controlled 
foreign corporation and the hybrid branch, or as if the hybrid branches 
of the partnership were hybrid branches of the controlled foreign 
corporation, if the hybrid branch payment is made between--
    (1) A fiscally transparent partnership in which a controlled 
foreign corporation is a partner (either directly or through one or 
more branches or other fiscally transparent partnerships) and the 
partnership's hybrid branch; or
    (2) Hybrid branches of a fiscally transparent partnership in which 
a controlled foreign corporation is a partner (either directly or 
through one or more branches or other fiscally transparent 
partnerships).
    (B) Non-fiscally transparent partnership. To the extent of the 
controlled foreign corporation's proportionate share of a hybrid branch 
payment, the rules of paragraphs (a)(3) and (4) and (a)(5)(iv) of this 
section shall be applied to the non-fiscally transparent partnership as 
if it were the controlled foreign corporation, if the hybrid branch 
payment is made between--
    (1) A non-fiscally transparent partnership in which a controlled 
foreign corporation is a partner (either directly or through one or 
more branches or other partnerships) and the partnership's hybrid 
branch; or
    (2) Hybrid branches of a non-fiscally transparent partnership in 
which a controlled foreign corporation is a partner (either directly or 
through one or more branches or other partnerships).
    (C) Examples. The following examples illustrate the application of 
this paragraph (a)(2)(ii).

    Example 1. CFC, a controlled foreign corporation in Country A, 
is a 90 percent partner in partnership P, which is treated as 
fiscally transparent under the laws of Country A. P has a hybrid 
branch, BR, in Country B. P makes an interest payment of $100 to BR. 
Under Country A law, CFC's 90 percent share of the payment reduces 
CFC's Country A income tax. Under paragraph (a)(2)(ii)(A) of this 
section, the recharacterization rules of this section are applied by 
treating the payment as if made by CFC to BR. Ninety dollars of 
CFC's non-subpart F income, to the extent available, and subject to 
the earnings and profits and tax rate limitations of Sec. 1.954-
9T(a)(5), is recharacterized as subpart F income.
    Example 2. CFC, a controlled foreign corporation in Country A, 
is a 90 percent partner in partnership P, which is treated as 
fiscally transparent under the laws of Country A. P has two branches 
in Country B, BR1 and BR2. BR1 is treated as fiscally transparent 
under the laws of Country A. BR2 is a hybrid branch. BR1 makes an 
interest payment of $100 to BR2. Under paragraph (a)(2)(ii)(A) of 
this section, the payment by BR1, the fiscally transparent branch, 
is treated as a payment by P, and the deemed payment by P, a 
fiscally transparent partnership, is treated as made by CFC. Under 
Country A law, CFC's 90 percent share of BR1's payment reduces CFC's 
Country A income tax. Ninety dollars of CFC's non-subpart F income, 
to the extent available, and subject to the earnings and profits and 
tax rate limitations of Sec. 1.954-9T(a)(5), is recharacterized as 
subpart F income.

    (3) Application when payment reduces foreign tax. For purposes of 
paragraph (a)(1) of this section, a hybrid branch payment reduces 
foreign tax when the foreign tax imposed on the

[[Page 14618]]

income of the payor or any owner of the payor is less than the foreign 
tax that would have been imposed on such income had the hybrid branch 
payment not been made, or the hybrid branch payment creates or 
increases a loss or deficit or other tax attribute which may be carried 
back or forward to reduce the foreign income tax of the payor or any 
owner in another year (determined by taking into account any refund of 
such tax made to the payor, payee or any other person).
    (4) Hybrid branch payment that is included within a category of 
foreign personal holding company income--(i) In general. For purposes 
of paragraph (a)(1) of this section, whether the hybrid branch payment 
is treated as income included within a category of foreign personal 
holding company income is determined by treating a hybrid branch that 
is either the payor or recipient of the hybrid branch payment as a 
separate wholly-owned subsidiary corporation of the controlled foreign 
corporation that is incorporated in the jurisdiction under the laws of 
which such hybrid branch is created, organized for foreign law 
purposes, or has substantial assets. Thus, the hybrid branch payment 
will be treated as included within a category of foreign personal 
holding company income if, taking into account any specific exceptions 
for that category, the payment would be included within a category of 
foreign personal holding company income if the branch or branches were 
treated as separately incorporated for U.S. tax purposes.
    (ii) Extent to which controlled foreign corporation and hybrid 
branches treated as separate entities. For purposes other than the 
determination under paragraph (a)(4)(i) of this section, a controlled 
foreign corporation and its hybrid branch, a partnership and its hybrid 
branch, or hybrid branches shall not be treated as separate entities. 
Thus, for example, if a controlled foreign corporation, including all 
of its hybrid branches, has an overall deficit in earnings and profits 
to which section 952(c) applies, the limitation of such section on the 
amount includible in the subpart F income of such corporation will 
apply. Similarly, for purposes of applying the de minimis and full 
inclusion rules of section 954(b)(3), a controlled foreign corporation 
and its hybrid branch, or hybrid branches shall not be treated as 
separate corporations. Further, a hybrid branch payment that would 
reduce foreign personal holding company income under section 954(b)(5) 
if made between two separate entities will not create an expense if 
made between a controlled foreign corporation and its hybrid branch, a 
partnership and its hybrid branch, or hybrid branches.
    (5) Recharacterization of income attributable to current earnings 
and profits as subpart F income--(i) General rule. Non-subpart F income 
of a controlled foreign corporation in an amount equal to the excess of 
earnings and profits of the controlled foreign corporation for the 
taxable year over subpart F income, as defined in section 952(a), will 
be recharacterized as subpart F income under paragraph (a)(1) of this 
section only to the extent provided under paragraphs (a)(5)(ii) through 
(vi) of this section.
    (ii) Subpart F income. For purposes of determining the excess of 
current earnings and profits over subpart F income under paragraph 
(a)(1) of this section, the amount of subpart F income is determined 
before the application of the rules of this section but after the 
application of the rules of sections 952(c) and 954(b). Further, such 
amount is determined by treating the controlled foreign corporation and 
all of its hybrid branches as a single corporation.
    (iii) Recharacterization limited to gross amount of hybrid branch 
payment--(A) In general. The amount recharacterized as subpart F income 
under paragraph (a)(1) of this section is limited to the amount of the 
hybrid branch payment.
    (B) Exception for duplicative payments. [Reserved].
    (iv) Tax disparity rule--(A) In general. Paragraph (a)(1) of this 
section will apply only if the hybrid branch payment falls within the 
tax disparity rule. The hybrid branch payment falls within the tax 
disparity rule if it is taxed in the year when earned at an effective 
rate of tax that is less than 90 percent of, and at least 5 percentage 
points less than, the hypothetical effective rate of tax imposed on the 
hybrid branch payment, as determined under paragraph (a)(5)(iv)(B) of 
this section.
    (B) Hypothetical effective rate of tax--(1) In general. The 
hypothetical effective rate of tax imposed on the hybrid branch payment 
is--
    (i) For the taxable year of the payor in which the hybrid branch 
payment is made, the amount of income taxes that would have been paid 
or accrued by the payor if the hybrid branch payment had not been made, 
less the amount of income taxes paid or accrued by the payor; divided 
by
    (ii) The amount of the hybrid branch payment.
    (2) Hypothetical effective rate of tax when hybrid branch payment 
causes or increases loss or deficit. If the hybrid branch payment 
causes or increases a loss or deficit of the payor for foreign tax 
purposes, and such loss or deficit can be carried forward or back, the 
hypothetical effective rate of tax imposed on the hybrid branch payment 
is the effective rate of tax that would be imposed on the taxable 
income of the payor for the year in which the foreign law payment is 
made if the payor's taxable income were equal to the amount of the 
hybrid branch payment.
    (C) Examples. The application of this paragraph (a)(5)(iv) is 
illustrated by the following examples.

    Example 1. In 1998, CFC organized in Country A had net income of 
$60 from manufacturing for Country A tax purposes. It also had a 
branch (BR) in Country B. BR is a hybrid entity under paragraph 
(a)(1) of this section. CFC made a payment of $40 to BR, which was a 
hybrid branch payment under paragraph (a)(6) of this section, and 
was treated by CFC as a deductible payment for Country A tax 
purposes. CFC paid $30 of Country A taxes in 1998. It would have 
paid $50 of Country A taxes without the deductible payment. Country 
A did not impose any withholding tax on the $40 payment to BR. 
Country B also did not impose a tax on the $40 received by BR. 
Therefore, the effective rate of tax on that payment is 0%. 
Furthermore, the hypothetical effective rate of tax on the $40 
hybrid branch payment is 50% ($50-$30/$40). The effective rate of 
tax (0%) is less than 90% of, and more than 5 percentage points less 
than, this hypothetical rate of tax of 50%. As a result, the $40 
hybrid branch payment falls within the tax disparity rule of this 
paragraph (a)(5)(iv).
    Example 2. Assume the same facts as in Example 1, except that 
CFC has a loss of $100 for the year for Country A tax purposes. 
Under Country A law, CFC can carry the loss forward for use in 
subsequent years. CFC paid no Country A taxes in 1998. The rate of 
tax in Country A is graduated from 20% to 50%. If the $40 hybrid 
branch payment were the only item of taxable income of CFC, Country 
A would have imposed tax at an effective rate of 30%. The effective 
rate of tax (0%) is less than 90 percent of, and more than 5 
percentage points less than, the hypothetical effective rate of tax 
(30%) imposed on the hybrid branch payment. As a result, the $40 
hybrid branch payment falls within the tax disparity rule of this 
paragraph (a)(5)(iv).
    Example 3. Assume the same facts as in Example 1, except that 
Country B imposes tax on the $40 hybrid payment to BR at an 
effective rate of 50%. The effective rate of 50% is equal to the 
hypothetical effective rate of tax. As a result, the hybrid branch 
payment does not fall within the tax disparity rule of this 
paragraph (a)(5)(iv) and, thus, the recharacterization rules of 
paragraph (a)(1) of this section do not apply. See also the special 
high tax exception of paragraph (a)(5)(v) of this section.

    (v) Special high tax exception--(A) In general. Paragraph (a)(1) of 
this section shall not apply if the non-subpart F income 
recharacterized as subpart F

[[Page 14619]]

income under this section was subject to foreign income taxes imposed 
by a foreign country or countries at an effective rate that is greater 
than 90 percent of the maximum rate of tax specified in section 11 for 
the taxable year of the controlled foreign corporation.
    (B) Effective rate of tax. The effective rate of tax imposed on the 
net amount of the hybrid branch payment is determined under the 
principles of Sec. 1.954-1(d)(2) and (3). See paragraph (c) of this 
section for the application of section 960 to amounts recharacterized 
as subpart F income under this section.
    (vi) No carryback or carryforward of amounts in excess of current 
year earnings and profits limitation. To the extent that some or all of 
the amount required to be recharacterized under this section is not 
recharacterized as subpart F income because the hybrid branch payment 
exceeds the amount that can be recharacterized, as determined under 
paragraph (a)(5)(i) of this section, this excess shall not be carried 
back or forward to another year.
    (6) Definitions. For purposes of this section--
    Entity means any person that is treated by the United States or any 
jurisdiction as other than an individual.
    Hybrid branch means an entity that--
    (i) Has a single owner (including ownership through branches) that 
is either a controlled foreign corporation or a partnership in which a 
controlled foreign corporation is a partner (either directly or 
indirectly through one or more branches or partnerships);
    (ii) Is treated as fiscally transparent by the United States; and
    (iii) Is treated as non-fiscally transparent by the country in 
which the payor entity, any owner of a fiscally-transparent payor 
entity, the controlled foreign corporation, or any intermediary 
partnership is created, organized or has substantial assets.
    Hybrid branch payment means the gross amount of any payment 
(including any accrual) which, under the tax laws of any foreign 
jurisdiction to which the payor is subject, is regarded as a payment 
between two separate entities but which, under U.S. income tax 
principles, is not income to the recipient because it is between two 
parts of a single entity.
    (7) Fiscally transparent and non-fiscally transparent. For purposes 
of this section an entity shall be treated as fiscally transparent with 
respect to an interest holder of the entity, if such interest holder is 
required, under the laws of any jurisdiction to which it is subject, to 
take into account separately, on a current basis, such interest 
holder's share of all items which, if separately taken into account by 
such interest holder, would result in an income tax liability for the 
interest holder in such jurisdiction different from that which would 
result if the interest holder did not take the share of such items into 
account separately. A non-fiscally transparent entity is an entity that 
is not fiscally transparent under this paragraph (a)(7).
    (b) Election to change classification--(1) In general. If a hybrid 
branch subject to the provisions of paragraph (a) of this section is an 
entity that has made an election under Sec. 301.7701-3(c)(1) of this 
chapter to be disregarded as an entity separate from its owner, such 
entity may elect to change its classification to that of an association 
taxable as a corporation, under the procedures described in 
Sec. 301.7701-3(c) of this chapter, without regard to the limitation of 
Sec. 301.7701-3T(c)(1)(iv) of this chapter, but only if such election 
is made on or before the last day of the first taxable year beginning 
on or after January 1, 1998. An election made pursuant to this 
paragraph (b)(1) is effective as of the first day of such taxable year. 
The 75 day limitation on retroactivity in Sec. 301.7701-3(c)(1)(iii) of 
this chapter does not apply.
    (2) Limitation. An entity can elect to change its classification 
under the provisions of this paragraph only one time.
    (c) Application of section 960--For purposes of determining the 
amount of taxes deemed paid under section 960, the amount of non-
subpart F income recharacterized as subpart F income under this section 
shall be treated as attributable to income in separate categories, as 
defined in Sec. 1.904-5(a)(1), in proportion to the ratio of non-
subpart F income in each such category to the total amount of non-
subpart F income of the controlled foreign corporation for the taxable 
year.
    (d) Effective dates--(1) Hybrid branches of controlled foreign 
corporations. With respect to hybrid branch payments described in 
paragraph (a)(2)(i)(A) and (B) of this section, the rules of this 
section shall apply to all amounts paid or accrued on or after January 
16, 1998, except for amounts paid or accrued pursuant to arrangements 
entered into before January 16, 1998, and not substantially modified 
(including, for example, by expansion of the arrangement (whether by 
exercise of an option or otherwise) such as by an increase in the 
amount of or term of any borrowing, leasing or licensing constituting 
the arrangement, changes in direct or indirect control of any entity 
that is a party to the arrangement, or any similar measure which 
materially increases the tax benefit of the arrangement) on or after 
January 16, 1998.
    (2) Hybrid branches of partnerships in which controlled foreign 
corporations are partners. With respect to hybrid branch payments 
described in paragraph (a)(2)(i)(C) and (D) of this section, the rules 
of this section shall apply to all amounts paid or accrued on or after 
March 23, 1998, except for amounts paid or accrued pursuant to 
arrangements entered into before March 23, 1998 and not substantially 
modified (including, for example, by expansion of the arrangement 
(whether by exercise of an option or otherwise) such as by an increase 
in the amount of or term of any borrowing, leasing or licensing 
constituting the arrangement, changes in direct or indirect control of 
any entity that is a party to the arrangement, or any similar measure 
which materially increases the tax benefit of the arrangement) on or 
after March 23, 1998.

PART 301--PROCEDURE AND ADMINISTRATION

    Par. 9. The authority citation for 26 CFR part 301 continue to read 
in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 10. In Sec. 301.7701-3, paragraph (f)(1) is amended by adding 
a sentence at the end to read as follows:


Sec. 301.7701-3.  Classification of certain business entities.

* * * * *
    (f)(1) * * * Paragraphs (a), (c)(1)(iv) and (f) of this section do 
not apply on or after March 23, 1998. For rules applicable on or after 
March 23, 1998, see Sec. 301.7701-3T(a), (c)(1)(iv) and (f).
    Par. 11. Section 301.7701-3T is added to read as follows:


Sec. 301.7701-3T  Classification of certain business entities 
(temporary).

    (a) In general. A business entity that is not classified as 
corporation under Sec. 301.7701-2(b)(1), (3), (4), (5), (6), (7), or 
(8) (an eligible entity) can elect its classification for federal tax 
purposes as provided in this section. An eligible entity with at least 
two members can elect to be classified as either an association (and 
thus a corporation under Sec. 301.7701-2(b)(2)) or a partnership, and 
an eligible entity with a single owner can elect to be classified as an 
association or to be disregarded as an entity separate from its owner. 
Paragraph (b) of this section provides a default classification for an 
eligible entity that does not make an election.

[[Page 14620]]

Thus, elections are necessary only when an eligible entity chooses to 
be classified initially as other than the default classification or 
when an eligible entity chooses to change its classification. An entity 
whose classification is determined under the default classification 
retains that classification (regardless of any changes in the members' 
liability that occurs at any time during the time that the entity's 
classification is relevant as defined in paragraph (d) of this section) 
until the entity makes an election to change that classification under 
paragraph (c)(1) of this section. Paragraph (c) of this section 
provides rules for making express elections. Paragraph (d) provides 
special rules for foreign eligible entities. Paragraph (e) of this 
section provides special rules for classifying entities resulting from 
partnership terminations and divisions under section 708(b). Paragraph 
(f) of this section sets forth the effective date of this section and a 
special rule relating to prior periods. An entity that has elected to 
be disregarded as an entity separate from its owner may nevertheless be 
treated as a corporation for the limited purposes of Sec. 1.954-
9T(a)(4)(i) of this chapter.
    (b) through (c)(1)(iii) [Reserved]. For further guidance, see 
Sec. 301.7701-3(b) through (c)(1)(iii).
    (c)(1)(iv) Limitation. If an eligible entity makes an election 
under paragraph (c)(1)(i) of this section to change its classification 
(other than an election made by an existing entity to change its 
classification as of the effective date of this section), the entity 
cannot change its classification by election again during the sixty 
months succeeding the effective date of the election. However, the 
Commissioner may permit the entity to change its classification by 
election within the sixty months if more than fifty percent of the 
ownership interests in the entity as of the effective date of the 
subsequent election are owned by person that did not own any interests 
in the entity on the filing date or on the effective date of the 
entity's prior election. See Sec. 1.954-9T(b) of this chapter, for 
circumstances under which certain eligible entities may make an 
election to change their classification within the sixty-month period.
    (c)(1)(v) through (e) [Reserved]. For further guidance, see 
Sec. 301.7701-3(c)(1)(v) through (e).
    (f) Effective date. Section 301.7701-3T(a) and (c)(1)(iv) applies 
on or after March 23, 1998. For rules prior to March 23, 1998, see 
Sec. 301.7701-3(a) and (c)(1)(iv).
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
    Approved:
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 98-7891 Filed 3-23-98; 12:58 pm]
BILLING CODE 4830-01-U