[Federal Register Volume 65, Number 128 (Monday, July 3, 2000)]
[Rules and Regulations]
[Pages 40993-41000]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-16761]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8889]
RIN 1545-AV10


Guidance Regarding Claims for Certain Income Tax Convention 
Benefits

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to treaty 
withholding rates for items of income received by entities that are 
fiscally transparent in the United States and/or a foreign 
jurisdiction. The regulations affect the determination of tax treaty 
benefits available to foreign persons with respect to such items of 
income.

DATES: Effective Dates: These regulations are effective June 30, 2000.
    Applicability Dates: These regulations apply to items of income 
paid on or after June 30, 2000.

FOR FURTHER INFORMATION CONTACT: Shawn R. Pringle, (202) 622-3850 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains final regulations relating to the Income Tax 
Regulations (CFR part 1) under section 894 of the Internal Revenue Code 
(Code). On June 30, 1997, the IRS and Treasury issued temporary 
regulations (TD 8722 [1997-2 C.B. 81]) in the Federal Register (62 FR 
35673, as corrected at 62 FR 46876, 46877) under section 894 of the 
Code relating to eligibility for benefits under income tax treaties for 
payments to entities. A notice of proposed rulemaking ([1997-2 C.B. 
646]) cross-referencing the temporary regulations was also published in 
the same issue of the Federal Register (62 FR 35755).

Need for Changes

    Since the publication of TD 8722 and proposed regulation 
Sec. 1.894(d)(REG-104893-97, 62 FR 35755), the IRS and Treasury have 
received numerous comments. This Treasury decision contains changes 
made in response to some of those comments.

Explanation of Provisions

I. General

    These final section 894 regulations clarify the availability of 
treaty benefits with respect to an item of U.S. source income paid to 
an entity that is treated as fiscally transparent under the laws of one 
or more jurisdictions (including the United States) with respect to 
that item of income. An entity that is treated as fiscally transparent 
in one jurisdiction but not another is referred to as a hybrid entity. 
If an item of U.S. source income is paid to a hybrid entity, the United 
States may regard the entity as fiscally transparent with respect to 
the item of income and the foreign treaty jurisdiction may regard the 
entity as deriving the item of income. Alternatively, the United States 
may regard the entity as deriving the item of income under U.S. tax 
principles, but a foreign treaty jurisdiction may regard the entity as 
fiscally transparent and may therefore regard the interest holders as 
deriving the item of income. This dual classification may give rise to 
inappropriate and unintended results under tax treaties, such as double 
non-taxation or double taxation of the item of income, unless the tax 
treaties are interpreted to resolve the conflict of laws.
    These final regulations clarify how to apply U.S. treaties when the 
entity classification law of the United States and a foreign treaty 
jurisdiction conflict by providing that a reduced treaty rate for an 
item of U.S. source income is available only if the income is derived 
by a foreign recipient resident in the applicable treaty jurisdiction. 
This general rule, which has been simplified but not substantially 
changed from the rule contained in the temporary and

[[Page 40994]]

proposed section 894 regulations, is discussed in greater detail below.
    These final regulations are fully consistent with existing U.S. 
treaties. They rely on the basic principle that tax treaties are 
intended to relieve double taxation or excessive taxation. Accordingly, 
the United States and its treaty partners agree to cede part or all of 
their taxation rights on income arising from sources within their 
respective borders on the mutual understanding that the other party is 
asserting tax jurisdiction over the items of income. This objective is 
generally achieved through treaty provisions that limit or eliminate 
the tax that the source state may impose on income arising within its 
borders to the extent that the income is considered to be derived by a 
resident of the other jurisdiction. In general, an item of income will 
be considered derived by a resident for treaty purposes only when the 
residence country is asserting taxing jurisdiction over the item of 
income. However, the source state does not necessarily require, as a 
condition for ceding its taxing jurisdiction, that the income actually 
be taxed in the residence state or taxed at a rate commensurate with 
the rate imposed in the source state. The source state and the 
residence state may come to different conclusions regarding the 
appropriate taxation principles that apply to a particular type of 
taxpayer or a particular type of income. Such differences reflect how 
each state has decided to assert its taxing jurisdiction over that 
taxpayer or item of income and may or may not affect the source state's 
willingness to forego its taxing rights in whole or in part during the 
treaty negotiation process.
    The approach adopted in these final regulations is consistent with 
the evolving multilateral consensus among the member countries of the 
Organization for Economic Cooperation and Development (OECD) on the 
appropriate method for source countries to follow to determine if they 
should provide treaty benefits on items of income paid to fiscally 
transparent entities, particularly when an entity classification 
conflict exists between the source and residence states. This evolving 
multilateral consensus is described in greater detail in the OECD 
report, ``The Application of the OECD Model Tax Convention to 
Partnerships'' (OECD Partnership Report). The report generally provides 
that a source state is required to grant treaty benefits on income paid 
to an entity only if the income is considered to be derived by a 
resident of a treaty partner for purposes of the treaty partner's tax 
laws. IRS and Treasury will continue to coordinate these issues with 
U.S. tax treaty partners both bilaterally and multilaterally to resolve 
substantive issues arising from application of the principles set forth 
in the section 894 regulations and the OECD Partnership Report.
    These regulations apply with respect to all U.S. income tax 
treaties regardless of whether such treaties contain partnership 
provisions, unless the competent authorities agree otherwise. As with 
the proposed and temporary regulations, the final regulations address 
only the treatment of U.S. source income that is not effectively 
connected with the conduct of a U.S. trade or business. The IRS and 
Treasury may issue additional regulations addressing the availability 
of other tax treaty benefits, such as the application of business 
profits provisions, with respect to the income of fiscally transparent 
entities, particularly where a conflict in entity classification 
exists.

II. Objective Versus Subjective Regulatory Approach

    The temporary and proposed section 894 regulations adopted an 
objective approach to determining whether the United States should 
grant treaty benefits on U.S. source items of income paid to entities. 
Application of the regulations did not turn on whether there existed a 
tax avoidance motive for choosing a particular transaction or 
structure.
    Commentators recommended a narrower approach that would deny treaty 
benefits on items of income paid to an entity only if the entity served 
a tax avoidance purpose. As part of this approach, commentators 
requested implementation of a ruling procedure that could be used to 
claim treaty benefits by rebutting any deemed tax avoidance motive for 
the items of income paid to an entity. This suggestion was not adopted. 
These final regulations are intended to provide objective rules 
regarding eligibility for treaty benefits on certain items of U.S. 
source income paid to entities. Although a ruling procedure was not 
adopted, taxpayers may still invoke the Mutual Agreement Procedures 
under an applicable treaty in appropriate circumstances.

III. Simplified Standard for Determining When U.S. Source Income Is 
Derived by a Treaty Resident

    The proposed and temporary regulations provided that the tax 
imposed by sections 871(a), 881(a), 1461, and 4948(a) on an item of 
income received by an entity is eligible for reduction under the terms 
of an income tax treaty to which the United States is a party if such 
item of income is treated as derived by a resident of an applicable 
treaty jurisdiction, such resident is a beneficial owner of the item of 
income, and all other applicable requirements for benefits under the 
treaty are satisfied. The proposed and temporary regulations further 
provided that an item of income received by an entity is treated as 
derived by a resident only to the extent the item of income is subject 
to tax in the hands of a resident of such jurisdiction. Numerous 
comments were received stating that this general rule needed 
clarification. As a result, the IRS and Treasury are eliminating the 
use of the terms beneficial ownership and subject to tax from the 
general rule, as described in greater detail below.
A. Beneficial Ownership
    Commentators requested clarification regarding the relationship 
between beneficial owner and the Sec. 1.881-3 anti-conduit regulations 
issued under the authority of section 7701(l). The anti-conduit rules 
under section 7701(l) are incorporated into the U.S. determination of 
beneficial owner. They are not separate additional requirements.
    The concept of beneficial owner was included in the proposed 
regulations to explain the circumstances under which a hybrid entity 
may beneficially own an item of income for purposes of an income tax 
treaty, in light of the then proposed withholding regulations under 
Sec. 1.1441-1(c)(6)(ii)(B). However, the definition of beneficial owner 
in Sec. 1.1441-1(c)(6) of the amended final regulations (TD 8881 [2000-
23 I.R.B 1158]) does not apply to claims for reduced withholding under 
an income tax treaty. Accordingly, because there is no longer a need to 
clarify the meaning of the term under the section 1441 regulations in 
the treaty context, these final regulations no longer provide specific 
rules for this determination. The concept of beneficial owner 
nevertheless remains an important condition for claiming tax treaty 
benefits that is determined under U.S. tax principles, including the 
anti-conduit rules.
B. Subject to Tax
    Commentators suggested that the term subject to tax in the proposed 
and temporary regulations was ambiguous and could be misinterpreted. 
Commentators suggested that the term subject to tax could be 
interpreted as requiring that an actual tax be paid rather than 
requiring an exercise of taxing jurisdiction by the applicable treaty 
jurisdiction, whether or not there

[[Page 40995]]

is an actual tax paid. Commentators suggested that such an 
interpretation would lead to anomalous results, for example, in cases 
when the applicable treaty jurisdiction provides an exemption from 
income for U.S. source dividends under its tax laws.
    The IRS and Treasury agree that the term subject to tax could cause 
unintentional confusion and that a more direct and simpler way of 
ensuring that an item of income is subject to the taxing jurisdiction 
of the residence country is to determine if the item of income is 
derived by a resident of a treaty jurisdiction. The concept of derived 
by a resident is a more useful surrogate for the concept of subject to 
the taxing jurisdiction of the residence state, the necessary 
prerequisite for the grant of treaty benefits on an item of income.
C. New General Rule Based on ``Derived By'' Standard
    The regulations now provide three specific situations in which 
income is derived by a resident of a treaty jurisdiction, and thus 
considered subject to the taxing jurisdiction of the residence 
jurisdiction and eligible for treaty benefits.
    In the first situation, an item of income paid to an entity is 
considered to be derived by the entity if the entity is not fiscally 
transparent with respect to the item of income under the laws of the 
entity's jurisdiction. The entity's jurisdiction is generally the place 
of the entity's organization, although it may be the place of 
management and control of the entity if it is a resident in a 
jurisdiction by reason of such factors.
    In the second situation, regardless of whether the entity is found 
to be fiscally transparent with respect to the item of income under the 
laws of the entity's jurisdiction, an interest holder in the entity may 
derive the item of income if that interest holder can establish that, 
under the laws of the jurisdiction in which the interest holder is a 
resident, the entity is fiscally transparent with respect to the item 
of income. Under this test, the interest holder itself must not be 
considered fiscally transparent with respect to the item of income 
under the laws of its jurisdiction in order to claim the treaty benefit 
of that jurisdiction.
    In the third situation, an item of income paid to a type of entity 
specifically listed in a treaty as a resident of that treaty 
jurisdiction is treated as derived by a resident of that jurisdiction. 
The reason for this rule is that the two treaty partners reached an 
explicit agreement on the appropriate treatment of that entity and 
treaty benefits accordingly should be provided on items of income paid 
to it.
    In some circumstances, both the entity and the interest holders in 
the entity will be treated as deriving the item of income under the 
foregoing tests. In that event, both the interest holder and the entity 
may be entitled to treaty benefits if all other conditions are 
satisfied. See Sec. 1.1441-6(b)(2) for procedures for dual rate claims 
under separate income tax treaties.

IV. Determining Fiscal Transparency

A. Generally
    The concept of fiscally transparent therefore is critical to the 
determination of whether an item of income is derived by an entity or 
an interest holder in an entity. Paragraph (d)(4)(ii) of the proposed 
and temporary regulations provided that an entity is treated as 
fiscally transparent by a jurisdiction to the extent the jurisdiction 
requires interest holders in the entity to take into account separately 
on a current basis their respective shares of the items of income paid 
to the entity and to determine the character of such item as if such 
items were realized directly from the source from which realized by the 
entity for purposes of the tax laws of the jurisdiction. The proposed 
and temporary regulations further provided that entities that are 
fiscally transparent for U.S. federal income tax purposes include 
partnerships, common trust funds described under section 584, simple 
trusts, grantor trusts, as well as certain other entities (including 
entities that have a single interest holder) that are treated as 
partnerships or as disregarded entities for U.S. federal income tax 
purposes.
    The IRS and Treasury received numerous comments regarding the 
definition of fiscally transparent under the proposed regulations. The 
comments stated that it is unclear, in situations when multiple foreign 
jurisdictions are involved, which jurisdiction's laws apply in 
determining whether an entity is fiscally transparent. The comments 
further stated that the requirement that all items of income be 
separately stated is not consistent with the U.S. tax rules regarding 
partnerships, which permit partners not to state separately certain 
items if the outcome is the same whether or not the item is separately 
stated. Commentators also suggested that the regulations were unclear 
as to whether fiscal transparency is an item by item determination or a 
determination made with respect to the entity as a whole.
    In response to the comments, several simplifying and clarifying 
changes were made to the regulations. When an entity is invoking the 
treaty, paragraph (d)(3)(ii) of the final regulations provides a 
definition for purposes of determining whether the entity will be 
treated as fiscally transparent under the laws of the entity's 
jurisdiction with respect to an item of income received by the entity. 
When an interest holder in an entity is invoking the treaty, paragraph 
(d)(3)(iii) of the final regulations provides a definition for purposes 
of determining whether the entity will be fiscally transparent under 
the laws of the interest holder's jurisdiction. This clarifies which 
jurisdiction's laws apply in determining fiscal transparency in cases 
in which multiple foreign jurisdictions are involved.
    Paragraphs (d)(3)(ii) and (iii) of the final regulations generally 
retain the definition of fiscally transparent as provided by the 
proposed and temporary regulations, with certain clarifications and 
modifications. They provide that an entity will be fiscally transparent 
only if inclusion by the interest holders in the entity is required 
whether or not an item of income is distributed to such interest 
holders and, generally, the character and source of the item in the 
hands of the interest holder are determined as if such item were 
realized directly from the source from which realized by the entity. 
They also provide that fiscal transparency is determined on an item of 
income by item of income basis. Accordingly, for example, an entity can 
be fiscally transparent with respect to interest income, but not with 
respect to dividend income. The regulations further provide, however, 
that if an item of income is not separately taken into account by its 
interest holders, the entity may still be fiscally transparent with 
respect to that item of income if failure to take the item of income 
into account separately does not result in a treatment under the tax 
laws of the applicable treaty jurisdiction different from that which 
would be required if the interest holder did separately take the share 
of such item into account. This is consistent with the U.S. tax 
provisions with respect to partnerships.
    Because the final regulations adopt an item by item determination 
of fiscal transparency, the provision in the proposed regulations 
stating that partnerships, common trust funds described in section 584, 
simple trusts, grantor trusts and certain other entities are fiscally 
transparent for U.S. federal income tax purposes has been deleted from 
the final regulations. The foregoing language implied that fiscal 
transparency is determined with respect to the entity as a whole. 
Although the

[[Page 40996]]

final regulations remove this language, it is anticipated that such 
entities ordinarily will be fiscally transparent for federal income tax 
purposes with regard to all items of income received by them.
B. Investment Vehicles
    Commentators also requested clarification regarding the treatment 
of investment vehicles that may be allowed an exclusion or deduction 
from income for amounts distributed to interest holders. The final 
regulations clarify that if an entity such as an investment company is 
not otherwise fiscally transparent as defined in paragraphs (d)(3)(ii) 
and (iii) of the final regulations, it will not be deemed to be 
fiscally transparent merely because it is allowed to exclude or deduct 
from income amounts distributed to interest holders. Examples provide 
further guidance with respect to foreign investment vehicles, most of 
which will not be fiscally transparent under the final regulations.
C. Treatment of Tax Exempt Organizations
    In addition to the foregoing, several commentators suggested that 
the regulations undermine reciprocal treaty exemptions for pension 
funds and other tax exempt organizations by, for example, denying 
treaty benefits under circumstances when the fund or organization 
invests in U.S. LLCs that are treated as partnerships for purposes of 
U.S. tax law and as corporations under the laws of the applicable 
treaty jurisdiction. Treasury does not believe that the regulations 
conflict with U.S. treaty obligations to provide reduced treaty rates 
to pension funds and other tax exempt organizations investing in the 
United States. In most cases, the denial of benefits described by 
commentators can be avoided by ensuring that the pension fund or tax 
exempt organization invests directly or through an entity treated as 
fiscally transparent under the laws of the jurisdiction of the fund or 
organization, with the result that the fund or organization will still 
be able to claim exemptions under the applicable treaty. In addition, 
treaties may be negotiated that permit pensions and other tax exempt 
organizations to invest in the United States through nonfiscally 
transparent entities and still obtain reduced treaty rates. (See for 
example paragraph 2(b) of Article XXI of the U.S.-Canada treaty, with 
respect to pension funds). Further, paragraph (d)(4) gives the 
competent authorities the flexibility, in appropriate circumstances, to 
enter into a mutual reciprocal understanding that would depart from the 
rules of paragraph (d) with respect to certain classes of entities.
D. Treatment of Complex Trusts
    The proposed and temporary regulations did not specifically address 
the treatment of section 661 trusts that are permitted to accumulate 
income from year to year. Commentators suggested that they should be 
treated as fiscally transparent for U.S. tax purposes because, under 
section 662, the distributable net income of such trusts retains its 
character in the hands of the beneficiaries if it is distributed in the 
current year and not accumulated. The definitions of fiscally 
transparent as set forth in the final regulations provide that, in 
order for the entity to be fiscally transparent with respect to an item 
of income, the interest holder must be required to take that item of 
income into account in a taxable year whether or not the item is 
distributed, and generally the character and source of the item in the 
hands of the interest holder are determined as if such item were 
realized directly from the source from which realized by the entity.
    Thus, to the extent the beneficiaries of a trust are required under 
section 662 to take an item of the trust's income into account in a 
taxable year, whether or not the item is distributed, and the character 
and source of the item in the hands of the beneficiaries are determined 
as if such item were realized directly from the source from which 
realized by the entity, the trust will be treated as fiscally 
transparent for U.S. tax purposes with respect to that item of income. 
If inclusion by the interest holders is not required whether or not 
such item of income is distributed, or the character and source of the 
item in the hands of the interest holder are determined as if such item 
were realized directly from the source from which realized by the 
entity, the trust will not be treated as fiscally transparent for U.S. 
tax purposes. In determining whether a trust, or any other entity, is 
fiscally transparent with respect to an item of income under the laws 
of any other jurisdiction, the treatment of that item of income under 
the laws of that jurisdiction controls, not the treatment under U.S. 
laws.
E. Effect of Anti-Deferral Regimes
    Commentators also argued that controlled foreign corporations 
should be treated as fiscally transparent to the extent interest 
holders are required to account for the controlled foreign 
corporation's net passive income on a current basis. This suggestion 
was rejected because the nature of an inclusion under an anti-deferral 
regime is that of a deemed distribution of after-tax profits of the 
controlled foreign corporation, while an inclusion because an entity is 
fiscally transparent is in the nature of a share of the item of income 
itself, as if the interest holder realized the income directly. This 
follows from the definition of fiscal transparency contained in 
paragraph (d)(3)(iii), relating to whether an entity is fiscally 
transparent under the laws of the interest holder's jurisdiction.

V. Treatment of Payments To and From Domestic Reverse Hybrid Entities

    Section 1.894-1T(d)(3) provided guidance on the appropriate 
treatment of items of income paid to an entity that is treated as a 
domestic corporation for U.S. tax purposes but is treated as fiscally 
transparent under the laws of an interest holder's jurisdiction (a 
``domestic reverse hybrid'' entity). That section provided that 
Sec. 1.894-1T(d)(1) may not be applied to reduce the amount of federal 
income tax on U.S. source income received by a domestic reverse hybrid 
entity through application of an income tax treaty. Commentators 
expressed concern that this rule did not provide sufficient guidance 
and could lead to inappropriate results, noting that an item of income 
paid by a domestic reverse hybrid entity could be viewed as neither 
``received by'' the interest holder nor ``subject to tax'' because the 
interest holder's jurisdiction would treat the domestic reverse hybrid 
entity as fiscally transparent. Thus, the interest holder's 
jurisdiction would view the interest holder as ``receiving'' the items 
of income paid to the domestic reverse hybrid entity and as being 
``subject to tax'' on those items of income on an immediate basis, but 
may not recognize the items of income paid by the domestic reverse 
hybrid entity to the interest holder.
    The IRS and Treasury are also aware of certain abusive structures 
involving domestic reverse hybrid entities, which are designed to 
manipulate differences in U.S. and foreign entity classification rules 
to produce inappropriate reductions in U.S. tax. These transactions 
give rise to some of the same concerns that led to the promulgation of 
the temporary and proposed regulations and caused Congress to enact 
section 894(c). Treasury and the IRS expect to issue guidance shortly 
regarding payments by domestic reverse hybrid entities to their 
interest holders in a separate regulation package. Thus, these final 
regulations reserve on the question of eligibility for

[[Page 40997]]

treaty benefits with respect to payments by domestic reverse hybrid 
entities.

Effective Date

    The final regulations apply to items of income paid on or after 
June 30, 2000. Withholding agents should consider the effect of these 
regulations on their withholding obligations, including the need to 
obtain a new withholding certificate to confirm claims of treaty 
benefits for items of income paid on or after the effective date.

Special Analyses

    It has been determined that this treasury decision 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 Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and, because 
these regulations do not impose on small entities a collection of 
information requirement, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis 
is not required.
    Drafting Information: The principal author of these regulations is 
Shawn R. Pringle of the Office of Associate Chief Counsel 
(International). However, other personnel from the IRS and Treasury 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, CFR 26 part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority for part 1 is amended by revising the 
entry for section 1.894-1 to read in part as follows:

    Authority: 26 U.S.C. 7805. * * * Section 1.894-1 also issued 
under 26 U.S.C. 894 and 7701(l). * * *

    Par. 2. In Sec. 1.894-1, paragraph (d) is revised to read as 
follows:


Sec. 1.894-1  Income affected by treaty.

* * * * *
    (d) Special rule for items of income received by entities--(1) In 
general. The tax imposed by sections 871(a), 881(a), 1443, 1461, and 
4948(a) on an item of income received by an entity, wherever organized, 
that is fiscally transparent under the laws of the United States and/or 
any other jurisdiction with respect to an item of income shall be 
eligible for reduction under the terms of an income tax treaty to which 
the United States is a party only if the item of income is derived by a 
resident of the applicable treaty jurisdiction. For this purpose, an 
item of income may be derived by either the entity receiving the item 
of income or by the interest holders in the entity or, in certain 
circumstances, both. An item of income paid to an entity shall be 
considered to be derived by the entity only if the entity is not 
fiscally transparent under the laws of the entity's jurisdiction, as 
defined in paragraph (d)(3)(ii) of this section, with respect to the 
item of income. An item of income paid to an entity shall be considered 
to be derived by the interest holder in the entity only if the interest 
holder is not fiscally transparent in its jurisdiction with respect to 
the item of income and if the entity is considered to be fiscally 
transparent under the laws of the interest holder's jurisdiction with 
respect to the item of income, as defined in paragraph (d)(3)(iii) of 
this section. Notwithstanding the preceding two sentences, an item of 
income paid directly to a type of entity specifically identified in a 
treaty as a resident of a treaty jurisdiction shall be treated as 
derived by a resident of that treaty jurisdiction.
    (2) Application to domestic reverse hybrid entities--(i) In 
general. An income tax treaty may not apply to reduce the amount of 
federal income tax on U.S. source payments received by a domestic 
reverse hybrid entity. Further, notwithstanding paragraph (d)(1) of 
this section, the foreign interest holders of a domestic reverse hybrid 
entity are not entitled to the benefits of a reduction of U.S. income 
tax under an income tax treaty on items of income received from U.S. 
sources by such entity. A domestic reverse hybrid entity is a domestic 
entity that is treated as not fiscally transparent for U.S. tax 
purposes and as fiscally transparent under the laws of the interest 
holder's jurisdiction, with respect to the item of income received by 
the domestic entity.
    (ii) Payments by domestic reverse hybrid entities. [Reserved].
    (3) Definitions--(i) Entity. For purposes of this paragraph (d), 
the term entity shall mean any person that is treated by the United 
States or the applicable treaty jurisdiction as other than an 
individual. The term entity includes disregarded entities, including 
single member disregarded entities with individual owners.
    (ii) Fiscally transparent under the law of the entity's 
jurisdiction--(A) General rule. For purposes of this paragraph (d), an 
entity is fiscally transparent under the laws of the entity's 
jurisdiction with respect to an item of income to the extent that the 
laws of that jurisdiction require the interest holder in the entity, 
wherever resident, to separately take into account on a current basis 
the interest holder's respective share of the item of income paid to 
the entity, whether or not distributed to the interest holder, and the 
character and source of the item in the hands of the interest holder 
are determined as if such item were realized directly from the source 
from which realized by the entity. However, the entity will be fiscally 
transparent with respect to the item of income even if the item of 
income is not separately taken into account by the interest holder, 
provided the item of income, if separately taken into account by the 
interest holder, would not result in an income tax liability for that 
interest holder different from that which would result if the interest 
holder did not take the item into account separately, and provided the 
interest holder is required to take into account on a current basis the 
interest holder's share of all such nonseparately stated items of 
income paid to the entity, whether or not distributed to the interest 
holder. In determining whether an entity is fiscally transparent with 
respect to an item of income in the entity's jurisdiction, it is 
irrelevant that, under the laws of the entity's jurisdiction, the 
entity is permitted to exclude such item from gross income or that the 
entity is required to include such item in gross income but is entitled 
to a deduction for distributions to its interest holders.
    (B) Special definitions. For purposes of this paragraph (d)(3)(ii), 
an entity's jurisdiction is the jurisdiction where the entity is 
organized or incorporated or may otherwise be considered a resident 
under the laws of that jurisdiction. An interest holder will be treated 
as taking into account that person's share of income paid to an entity 
on a current basis even if such amount is taken into account by the 
interest holder in a taxable year other than the taxable year of the 
entity if the difference is due solely to differing taxable years.
    (iii) Fiscally transparent under the law of an interest holder's 
jurisdiction--(A) General rule. For purposes of this paragraph (d), an 
entity is treated as fiscally transparent under the law of an interest 
holder's jurisdiction with respect to an item of income to the extent 
that the laws of the interest holder's jurisdiction require the 
interest holder resident in that jurisdiction to separately take into 
account on a current basis the interest holder's respective share of 
the item of income paid to the

[[Page 40998]]

entity, whether or not distributed to the interest holder, and the 
character and source of the item in the hands of the interest holder 
are determined as if such item were realized directly from the source 
from which realized by the entity. However, an entity will be fiscally 
transparent with respect to the item of income even if the item of 
income is not separately taken into account by the interest holder, 
provided the item of income, if separately taken into account by the 
interest holder, would not result in an income tax liability for that 
interest holder different from that which would result if the interest 
holder did not take the item into account separately, and provided the 
interest holder is required to take into account on a current basis the 
interest holder's share of all such nonseparately stated items of 
income paid to the entity, whether or not distributed to the interest 
holder. An entity will not be treated as fiscally transparent with 
respect to an item of income under the laws of the interest holder's 
jurisdiction, however, if, under the laws of the interest holder's 
jurisdiction, the interest holder in the entity is required to include 
in gross income a share of all or a part of the entity's income on a 
current basis year under any type of anti-deferral or comparable 
mechanism. In determining whether an entity is fiscally transparent 
with respect to an item of income under the laws of an interest 
holder's jurisdiction, it is irrelevant how the entity is treated under 
the laws of the entity's jurisdiction.
    (B) Special definitions. For purposes of this paragraph 
(d)(3)(iii), an interest holder's jurisdiction is the jurisdiction 
where the interest holder is organized or incorporated or may otherwise 
be considered a resident under the laws of that jurisdiction. An 
interest holder will be treated as taking into account that person's 
share of income paid to an entity on a current basis even if such 
amount is taken into account by such person in a taxable year other 
than the taxable year of the entity if the difference is due solely to 
differing taxable years.
    (iv) Applicable treaty jurisdiction. The term applicable treaty 
jurisdiction means the jurisdiction whose income tax treaty with the 
United States is invoked for purposes of reducing the rate of tax 
imposed under sections 871(a), 881(a), 1461, and 4948(a).
    (v) Resident. The term resident shall have the meaning assigned to 
such term in the applicable income tax treaty.
    (4) Application to all income tax treaties. Unless otherwise 
explicitly agreed upon in the text of an income tax treaty, the rules 
contained in this paragraph (d) shall apply in respect of all income 
tax treaties to which the United States is a party. Notwithstanding the 
foregoing sentence, the competent authorities may agree on a mutual 
basis to depart from the rules contained in this paragraph (d) in 
appropriate circumstances. However, a reduced rate under a tax treaty 
for an item of U.S. source income paid will not be available 
irrespective of the provisions in this paragraph (d) to the extent that 
the applicable treaty jurisdiction would not grant a reduced rate under 
the tax treaty to a U.S. resident in similar circumstances, as 
evidenced by a mutual agreement between the relevant competent 
authorities or by a public notice of the treaty jurisdiction. The 
Internal Revenue Service shall announce the terms of any such mutual 
agreement or public notice of the treaty jurisdiction. Any denial of 
tax treaty benefits as a consequence of such a mutual agreement or 
notice shall affect only payment of U.S. source items of income made 
after announcement of the terms of the agreement or of the notice.
    (5) Examples. This paragraph (d) is illustrated by the following 
examples:

    Example 1. Treatment of entity treated as partnership by U.S. 
and country of organization. (i) Facts. Entity A is a business 
organization formed under the laws of Country X that has an income 
tax treaty in effect with the United States. A is treated as a 
partnership for U.S. federal income tax purposes. A is also treated 
as a partnership under the laws of Country X, and therefore Country 
X requires the interest holders in A to separately take into account 
on a current basis their respective shares of the items of income 
paid to A, whether or not distributed to the interest holders, and 
the character and source of the items in the hands of the interest 
holders are determined as if such items were realized directly from 
the source from which realized by A. A receives royalty income from 
U.S. sources that is not effectively connected with the conduct of a 
trade or business in the United States.
    (ii) Analysis. A is fiscally transparent in its jurisdiction 
within the meaning of paragraph (d)(3)(ii) of this section with 
respect to the U.S. source royalty income in Country X and, thus, A 
does not derive such income for purposes of the U.S.-X income tax 
treaty.
    Example 2. Treatment of interest holders in entity treated as 
partnership by U.S. and country of organization. (i) Facts. The 
facts are the same as under Example 1. A's partners are M, a 
corporation organized under the laws of Country Y that has an income 
tax treaty in effect with the United States, and T, a corporation 
organized under the laws of Country Z that has an income tax treaty 
in effect with the United States. M and T are not fiscally 
transparent under the laws of their respective countries of 
incorporation. Country Y requires M to separately take into account 
on a current basis M's respective share of the items of income paid 
to A, whether or not distributed to M, and the character and source 
of the items of income in M's hands are determined as if such items 
were realized directly from the source from which realized by A. 
Country Z treats A as a corporation and does not require T to take 
its share of A's income into account on a current basis whether or 
not distributed.
    (ii) Analysis. M is treated as deriving its share of the U.S. 
source royalty income for purposes of the U.S.-Y income tax treaty 
because A is fiscally transparent under paragraph (d)(3)(iii) with 
respect to that income under the laws of Country Y. Under Country Z 
law, however, because T is not required to take into account its 
share of the U.S. source royalty income received by A on a current 
basis whether or not distributed, A is not treated as fiscally 
transparent. Accordingly, T is not treated as deriving its share of 
the U.S. source royalty income for purposes of the U.S.-Z income tax 
treaty.
    Example 3. Dual benefits to entity and interest holder. (i) 
Facts. The facts are the same as under Example 2, except that A is 
taxable as a corporation under the laws of Country X. Article 12 of 
the U.S.-X income tax treaty provides for a source country reduced 
rate of taxation on royalties of 5-percent. Article 12 of the U.S.-Y 
income tax treaty provides that royalty income may only be taxed by 
the beneficial owner's country of residence.
    (ii) Analysis. A is treated as deriving the U.S. source royalty 
income for purposes of the U.S.-X income tax treaty because it is 
not fiscally transparent with respect to the item of income within 
the meaning of paragraph (d)(3)(ii) of this section in Country X, 
its country of organization. M is also treated as deriving its share 
of the U.S. source royalty income for purposes of the U.S.-Y income 
tax treaty because A is fiscally transparent under paragraph 
(d)(3)(iii) of this section with respect to that income under the 
laws of Country Y. T is not treated as deriving the U.S. source 
royalty income for purposes of the U.S.-Z income tax treaty because 
under Country Z law A is not fiscally transparent. Assuming all 
other requirements for eligibility for treaty benefits have been 
satisfied, A is entitled to the 5-percent treaty reduced rate on 
royalties under the U.S.-X income tax treaty with respect to the 
entire royalty payment. Assuming all other requirements for treaty 
benefits have been satisfied, M is also entitled to a zero rate 
under the U.S.-Y income tax treaty with respect to its share of the 
royalty income.
    Example 4. Treatment of grantor trust. (i) Facts. Entity A is a 
trust organized under the laws of Country X, which does not have an 
income tax treaty in effect with the United States. M, the grantor 
and owner of A for U.S. income tax purposes, is a resident of 
Country Y, which has an income tax treaty in effect with the United 
States. M is also treated as the grantor and owner of the trust 
under the laws of Country Y. Thus, Country Y requires M to take into 
account all items of A's income in the taxable year, whether or not 
distributed to M, and determines the character of each item in M's 
hands as if such item was realized directly from the source

[[Page 40999]]

from which realized by A. Country X does not treat M as the owner of 
A and does not require M to account for A's income on a current 
basis whether or not distributed to M. A receives interest income 
from U.S. sources that is neither portfolio interest nor effectively 
connected with the conduct of a trade or business in the United 
States.
    (ii) Analysis. A is not fiscally transparent under the laws of 
Country X within the meaning of paragraph (d)(3)(ii) of this section 
with respect to the U.S. source interest income, but A may not claim 
treaty benefits because there is no U.S.-X income tax treaty. M, 
however, does derive the income for purposes of the U.S.-Y income 
tax treaty because under the laws of Country Y, A is fiscally 
transparent.
    Example 5. Treatment of complex trust. (i) Facts. The facts are 
the same as in Example 4 except that M is treated as the owner of 
the trust only under U.S. tax law, after application of section 
672(f), but not under the law of Country Y. Although the trust 
document governing A does not require that A distribute any of its 
income on a current basis, some distributions are made currently to 
M. There is no requirement under Country Y law that M take into 
account A's income on a current basis whether or not distributed to 
him in that year. Under the laws of Country Y, with respect to 
current distributions, the character of the item of income in the 
hands of the interest holder is determined as if such item were 
realized directly from the source from which realized by A. 
Accordingly, upon a current distribution of interest income to M, 
the interest income retains its source as U.S. source income.
    (ii) Analysis. M does not derive the U.S. source interest income 
because A is not fiscally transparent under paragraph (d)(3)(ii) of 
this section with respect to the U.S. source interest income under 
the laws of Country Y. Although the character of the interest in the 
hands of M is determined as if realized directly from the source 
from which realized by A, under the laws of Country Y, M is not 
required to take into account his share of A's interest income on a 
current basis whether or not distributed. Accordingly, neither A nor 
M is entitled to claim treaty benefits, since A is a resident of a 
non-treaty jurisdiction and M does not derive the U.S. source 
interest income for purposes of the U.S.-Y income tax treaty.
    Example 6. Treatment of interest holders required to include 
passive income under anti-deferral regime. (i) Facts. The facts are 
the same as under Example 2. However, Country Z does require T, who 
is treated as owning 60-percent of the stock of A, to take into 
account its respective share of the royalty income of A under an 
anti-deferral regime applicable to certain passive income of 
controlled foreign corporations.
    (ii) Analysis. T is still not eligible to claim treaty benefits 
with respect to the royalty income. T is not treated as deriving the 
U.S. source royalty income for purposes of the U.S.-Z income tax 
treaty under paragraph (d)(3)(iii) of this section because T is only 
required to take into account its pro rata share of the U.S. source 
royalty income by reason of Country Z's anti-deferral regime.
    Example 7. Treatment of contractual arrangements operating as 
collective investment vehicles. (i) Facts. A is a contractual 
arrangement without legal personality for all purposes under the 
laws of Country X providing for joint ownership of securities. 
Country X has an income tax treaty in effect with the United States. 
A is a collective investment fund which is of a type known as a 
Common Fund under Country X law. Because of the absence of legal 
personality of the arrangement, A is not liable to tax at the entity 
level in Country X and is not a resident within the meaning of the 
Residence Article of the U.S.-X income tax treaty. A is treated as a 
partnership for U.S. income tax purposes and receives U.S. source 
dividend income. Under the laws of Country X, however, investors in 
A only take into account their respective share of A's income upon 
distribution from the Common Fund. Some of A's interest holders are 
residents of Country X and some of Country Y. Country Y has no 
income tax treaty in effect with the United States.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because the interest holders in A are not required to take 
into account their respective shares of such income in the taxable 
year whether or not distributed. Because A is an arrangement without 
a legal personality that is not considered a resident of Country X 
under the Residence Article of the U.S.-X income tax treaty, 
however, A does not derive the income for purposes of the U.S.-X 
income tax treaty. Further, because A is not fiscally transparent 
under paragraph (d)(3)(iii) of this section with respect to the U.S. 
source dividend income, A's interest holders that are residents of 
Country X do not derive the income as residents of Country X for 
purposes of the U.S.-X income tax treaty.
    Example 8. Treatment of person specifically listed as resident 
in applicable treaty. (i) Facts. The facts are the same as in 
Example 7 except that A (the Common Fund) is organized in Country Z 
and the Residence Article of the U.S.-Z income tax treaty provides 
that ``the term 'resident of a Contracting State' includes, in the 
case of Country Z, Common Funds.* * *''
    (ii) Analysis. A is treated, for purposes of the U.S.-Z income 
tax treaty as deriving the dividend income as a resident of Country 
Z under paragraph (d)(1) of this section because the item of income 
is paid directly to A, A is a Common Fund under the laws of Country 
Z, and Common Funds are specifically identified as residents of 
Country Z in the U.S.-Z treaty. There is no need to determine 
whether A meets the definition of fiscally transparent under 
paragraph (d)(3)(ii) of this section.
    Example 9. Treatment of investment company when entity receives 
distribution deductions, and all distributions sourced by residence 
of entity. (i) Facts. Entity A is a business organization formed 
under the laws of Country X, which has an income tax treaty in 
effect with the United States. A is treated as a partnership for 
U.S. income tax purposes. Under the laws of Country X, A is an 
investment company taxable at the entity level and a resident of 
Country X. It is also entitled to a distribution deduction for 
amounts distributed to its interest holders on a current basis. A 
distributes all its net income on a current basis to its interest 
holders and, thus, in fact, has no income tax liability to Country 
X. A receives U.S. source dividend income. Under Country X law, all 
amounts distributed to interest holders of this type of business 
entity are treated as dividends from sources within Country X and 
Country X imposes a withholding tax on all payments by A to foreign 
persons. Under Country X laws, the interest holders in A do not have 
to separately take into account their respective shares of A's 
income on a current basis if such income is not, in fact, 
distributed.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividends 
because the interest holders in A do not have to take into account 
their respective share of the U.S. source dividends on a current 
basis whether or not distributed. A is also not fiscally transparent 
under paragraph (d)(3)(ii) of this section because there is a change 
in source of the income received by A when A distributes the income 
to its interest holders and, thus, the character and source of the 
income in the hands of A's interest holder are not determined as if 
such income were realized directly from the source from which 
realized by A. Accordingly, A is treated as deriving the U.S. source 
dividends for purposes of the U.S.-Country X treaty.
    Example 10. Item by item determination of fiscal transparency. 
(i) Facts. Entity A is a business organization formed under the laws 
of Country X, which has an income tax treaty in effect with the 
United States. A is treated as a partnership for U.S. income tax 
purposes. Under the laws of Country X, A is an investment company 
taxable at the entity level and a resident of Country X. It is also 
entitled to a distribution deduction for amounts distributed to its 
interest holders on a current basis. A receives both U.S. source 
dividend income and interest income from U.S. sources that is 
neither portfolio interest nor effectively connected with the 
conduct of a trade or business in the United States. Country X law 
sources all distributions attributable to dividend income based on 
the residence of the investment company. In contrast, Country X law 
sources all distributions attributable to interest income based on 
the residence of the payor of the interest. No withholding applies 
with respect to distributions attributable to U.S. source interest 
and the character of the distributions attributable to the interest 
income remains the same in the hands of A's interest holders as if 
such items were realized directly from the source from which 
realized by A. However, under Country X law the interest holders in 
A do not have to take into account their respective share of the 
interest income received by A on a current basis whether or not 
distributed.
    (ii) Analysis. An item by item analysis is required under 
paragraph (d) of this section. The analysis is the same as Example 9 
with respect to the dividend income. A is also not fiscally 
transparent under paragraph (d)(3)(ii) of this section with respect 
to the interest income because, although the character of the

[[Page 41000]]

distributions attributable to the interest income in the hands of 
A's interest holders is determined as if realized directly from the 
source from which realized by A, under Country X law the interest 
holders in A do not have to take into account their respective share 
of the interest income received by A on a current basis whether or 
not distributed. Accordingly, A derives the U.S. source interest 
income for purpose of the U.S.-X treaty.
    Example 11. Treatment of charitable organizations. (i) Facts. 
Entity A is a corporation organized under the laws of Country X that 
has an income tax treaty in effect with the United States. Entity A 
is established and operated exclusively for religious, charitable, 
scientific, artistic, cultural, or educational purposes. Entity A 
receives U.S. source dividend income from U.S. sources. A provision 
of Country X law generally exempts Entity A's income from Country X 
tax due to the fact that Entity A is established and operated 
exclusively for religious, charitable, scientific, artistic, 
cultural, or educational purposes. But for such provision, Entity 
A's income would be subject to tax by Country X.
    (ii) Analysis. Entity A is not fiscally transparent under 
paragraph (d)(3)(ii) of this section with respect to the U.S. source 
dividend income because, under Country X law, the dividend income is 
treated as an item of income of A and no other persons are required 
to take into account their respective share of the item of income on 
a current basis, whether or not distributed. Accordingly, Entity A 
is treated as deriving the U.S. source dividend income.
    Example 12. Treatment of pension trusts. (i) Facts. Entity A is 
a trust established and operated in Country X exclusively to provide 
pension or other similar benefits to employees pursuant to a plan. 
Entity A receives U.S. source dividend income. A provision of 
Country X law generally exempts Entity A's income from Country X tax 
due to the fact that Entity A is established and operated 
exclusively to provide pension or other similar benefits to 
employees pursuant to a plan. Under the laws of Country X, the 
beneficiaries of the trust are not required to take into account 
their respective share of A's income on a current basis, whether or 
not distributed and the character and source of the income in the 
hands of A's interest holders are not determined as if realized 
directly from the source from which realized by A.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because under the laws of Country X, the beneficiaries of A 
are not required to take into account their respective share of A's 
income on a current basis, whether or not distributed. A is also not 
fiscally transparent under paragraph (d)(3)(ii) of this section with 
respect to the U.S. source dividend income because under the laws of 
Country X, the character and source of the income in the hands of 
A's interest holders are not determined as if realized directly from 
the source from which realized by A. Accordingly, A derives the U.S. 
source dividend income for purposes of the U.S.-X income tax treaty.

    (6) Effective date. This paragraph (d) applies to items of income 
paid on or after June 30, 2000.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.

    Approved: June 28, 2000.
Jonathan Talisman,
Deputy Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 00-16761 Filed 6-30-00; 8:45 am]
BILLING CODE 4830-01-P