[Federal Register Volume 66, Number 39 (Tuesday, February 27, 2001)]
[Proposed Rules]
[Pages 12445-12448]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1687]



[[Page 12445]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-107101-00]
RIN 1545-AY13


Treaty Guidance Regarding Payments With Respect to Domestic 
Reverse Hybrid Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations under section 894 
of the Internal Revenue Code relating to the eligibility for treaty 
benefits of items of income paid by domestic entities that are not 
fiscally transparent under U.S. law but are fiscally transparent under 
the laws of the jurisdiction of the person claiming treaty benefits (a 
domestic reverse hybrid entity). The proposed regulations affect the 
determination of tax treaty benefits with respect to U.S. source income 
of foreign persons. This document also provides notice of a public 
hearing on these proposed regulations.

DATES: Written or electronic comments must be received by May 29, 2001. 
Requests to speak (with outlines of oral comments to be discussed) at 
the public hearing scheduled for June 26, 2001, at 10 a.m., must be 
submitted by June 5, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-107101-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to: CC:M&SP:RU (REG-107101-00), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. 
Alternatively, taxpayers may submit comments electronically via the 
Internet by selecting the ``Tax Regs'' option on the IRS Home Page, or 
by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/regslist.html. The public hearing will be held in 
the auditorium, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Elizabeth 
U. Karzon or Karen Rennie-Quarrie at (202) 622-3880; concerning 
submissions and the hearing, Guy R. Traynor at (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    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 Internal 
Revenue Code relating to eligibility for benefits under income tax 
treaties for payments to certain entities. These regulations addressed, 
among other matters, the eligibility for treaty benefits of U.S. source 
payments made to domestic reverse hybrid entities, concluding that 
treaty benefits were not available for such payments. 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). On July 3, 2000, the IRS and Treasury issued 
final regulations (TD 8889), reaffirming the position taken in the 
temporary regulations with respect to payments made to domestic reverse 
hybrid entities. The final regulations, however, did not address the 
question of whether payments made by domestic reverse hybrid entities 
to their interest holders are eligible for treaty benefits. Section 
1.894-1(d)(2)(ii) was reserved for further guidance on that issue.

Explanation of Provisions

    These proposed regulations provide guidance with respect to the 
previously reserved paragraph. They provide rules on the character of 
such payments for treaty purposes and the extent to which such payments 
are eligible for a reduced rate of U.S. tax under a U.S. income tax 
treaty. The use of domestic reverse hybrid entities may give rise to 
inappropriate and unintended results under income tax treaties, such as 
double non-taxation or double taxation, unless the income tax treaties 
are interpreted to resolve the conflict of laws. These regulations 
provide guidance regarding how to apply U.S. income tax treaties under 
these circumstances.
    Section 1.894-1T(d)(3) provided guidance on the appropriate 
treatment of items of income paid to 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. Thus, neither the domestic reverse hybrid entity nor its 
interest holders could claim a reduction under an income tax treaty 
with respect to a payment to a domestic reverse hybrid entity, 
notwithstanding that the interest holder might otherwise derive the 
income as a resident of a treaty jurisdiction under Sec. 1.894-
1T(d)(1). The rationale for the rule was the U.S. tax treaty principle 
that the United States retains taxing jurisdiction over items of U.S. 
source income paid to its residents. The final regulations published in 
the Federal Register on July 3, 2000, retain the rule that a domestic 
reverse hybrid entity remains subject to the taxing jurisdiction of the 
United States on U.S. source payments, but reserve with respect to the 
treatment of payments made by domestic reverse hybrid entities.
    Commentators on the previously issued temporary and proposed 
regulations noted that it was unclear how items of income paid by a 
domestic reverse hybrid entity to its interest holders should be 
treated. In particular, the general rule contained in Sec. 1.894-
1T(d)(1) required the item of income to be ``received by'' a person 
resident in a treaty jurisdiction and for that item of income to be 
``subject to tax'' in the hands of the person deriving the item of 
income. Commentators expressed concern 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 treats the domestic reverse hybrid entity as 
fiscally transparent. The interest holder's jurisdiction views 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. The interest holder's 
jurisdiction does not recognize the items of income paid by the 
domestic reverse hybrid entity to the interest holder. Based on this 
analysis, commentators questioned whether the items of income paid by 
the domestic reverse hybrid entity to an interest holder in that entity 
would be subject to a 30-percent tax under the Code. The IRS and 
Treasury believe similar questions may also arise under the recently 
issued final regulations.
    Accordingly, these proposed regulations provide rules on the 
treatment of payments made by domestic reverse hybrid entities. 
Paragraph (d)(2)(ii) of this section provides a general rule that an 
item of income paid by a domestic reverse hybrid entity to an interest 
holder shall be characterized under U.S. tax law. This means that U.S. 
tax principles are first applied to characterize the item of income 
paid by the domestic reverse hybrid entity to the interest holder for 
purposes of applying an applicable income tax treaty provision. Once 
the item of income is so characterized, it is

[[Page 12446]]

necessary to determine if the interest holder derives the item of 
income. In determining whether the interest holder derives the item of 
income, paragraph (d)(2)(ii)(A) of this section provides a special rule 
for determining whether the interest holder is fiscally transparent 
with respect to the item of income. Under that rule, whether the 
interest holder is fiscally transparent with respect to the item of 
income for purposes of Sec. 1.894-1(d)(3)(ii) is made based on the 
treatment that would have resulted had the item of income been paid by 
an entity that was not fiscally transparent under the laws of the 
interest holder's jurisdiction with respect to any item of income. 
Accordingly, if the interest holder is not fiscally transparent, then 
it will be considered to have derived the item of income, even if, for 
example, the item of income were characterized differently or treated 
as received at an earlier date under the laws of the interest holder's 
jurisdiction than the item of income paid by the domestic reverse 
hybrid entity.
    The IRS and Treasury have learned, however, that domestic reverse 
hybrid entities are being established by related parties to manipulate 
differences in U.S. and foreign entity classification rules to reduce 
inappropriately the amount of tax imposed on items of income paid from 
the United States to related foreign interest holders. In a typical 
scenario, a foreign investor, resident in a treaty jurisdiction, 
establishes a domestic reverse hybrid holding company with a 
combination of debt and equity contributions. The domestic reverse 
hybrid entity holds the stock of a wholly-owned U.S. operating company. 
The operating company pays a dividend to the domestic reverse hybrid 
entity, but the domestic reverse hybrid entity primarily pays interest 
to its foreign owner within the earning stripping limits of section 
163(j). The foreign jurisdiction views the foreign owner as receiving 
dividends, but the United States views the domestic reverse hybrid 
entity as receiving the dividends and making deductible interest 
payments. In circumstances when the income tax treaty between the 
United States and the applicable foreign jurisdiction applies a zero 
withholding rate on interest and a 5-percent rate on related party 
dividends, the domestic reverse hybrid entity treats its payment to the 
foreign owner as an interest payment and the foreign owner avoids the 
withholding tax on the dividends that its jurisdiction treats it as 
receiving. In addition, the domestic reverse hybrid entity receives the 
benefit of an interest deduction in the United States while the foreign 
interest holder receives either a tax credit or exclusion on the 
dividend amount in its jurisdiction.
    The IRS and Treasury believe that it is inappropriate for related 
parties to use domestic reverse hybrid entities for the purpose of 
converting higher taxed U.S. source items of income to lower taxed, or 
untaxed, U.S. source items of income. To do so defeats the expectation 
of the United States and its treaty partners that treaties should be 
used to reduce or eliminate double taxation for legitimate 
transactions, not to reward the manipulation of inconsistencies in the 
laws of the treaty partners. The legislative history of section 894(c) 
supports this analysis. Congress specifically expressed its concern 
about the potential tax avoidance opportunities available for foreign 
persons that invest in the United States through hybrid entities that 
are designed to avoid both U.S. and foreign income taxes. See H.R. 
Conf. Rep. No 220, 105th Cong, 1st Sess. 573 (1997); Joint Committee on 
Taxation, 105th Cong., 1st Sess., General Explanation of Tax 
Legislation Enacted in 1997 (JCS-23-97), at 249 (December 17, 1997). 
The approach contained in Sec. 1.894-1(d)(2), as revised, is also 
consistent with the general tax treaty principle that contracting 
states may adopt provisions in their domestic laws to counter 
structures and transactions intended to take advantage of the 
differences in the tax laws of the contracting states. See Commentaries 
to Article 1 of The 1998 OECD Model Tax Convention on Income and 
Capital; S. Rep. No. 445, 100th Cong. 2d Sess. 322-23 (1988).
    The IRS and Treasury are further concerned by the ability of 
foreign acquiring entities to obtain tax advantaged financing through 
domestic reverse hybrid entities by exploiting differences between U.S. 
and foreign law. Such financing unfairly disadvantages similarly 
situated U.S. domestic acquiring entities. Congress has expressed 
concern about the use of analogous hybridized structures that were 
effected to provide foreign acquiring entities with tax advantaged 
acquisition financing not available to similarly situated domestic 
companies. See Joint Committee on Taxation, 100th Congress, 1st Sess., 
General Explanation of the Tax Reform Act of 1986 (JCS-10-87), at 1064, 
1065 (May 4, 1987).
    For these reasons, the proposed regulations provide a special rule 
in paragraph (d)(2)(ii)(B) of the regulations, such that if: (1) a 
domestic entity makes a payment to a related domestic reverse hybrid 
entity that is considered to be a dividend either under the laws of the 
United States or under the laws of the jurisdiction of a related 
foreign interest holder in the domestic reverse hybrid entity, and the 
related foreign interest holder is treated as deriving its 
proportionate share of the payment to the domestic reverse hybrid 
entity under the laws of the related foreign interest holder's 
jurisdiction; and (2) the domestic reverse hybrid entity makes a 
payment to the related foreign interest holder of a type that is 
deductible for U.S. tax purposes and for which a reduction in the U.S. 
withholding tax rate would be allowed under the general rule, but for 
this exception, then to the extent the amount of the payment by the 
domestic reverse hybrid entity to the related foreign interest holder 
does not exceed the total amount of the interest holder's proportionate 
share of any payments by the domestic entity to the domestic reverse 
hybrid entity treated as dividends under either jurisdiction's laws, 
the payment by the domestic reverse hybrid entity shall be treated as a 
dividend for all purposes of the Code and the applicable income tax 
treaty.
    For purposes of determining the amount of the payment from the 
domestic reverse hybrid entity to the related foreign interest holder 
to be recharacterized as a dividend, the portion of the payments 
treated as derived by the related foreign interest holder shall be 
reduced by the amount of any prior actual dividend payments, under U.S. 
law, made by the domestic reverse hybrid entity to the related foreign 
interest holder and by the amount of any payments from the domestic 
reverse hybrid entity to the related foreign interest holder previously 
recharacterized under this special rule. The tax withheld from the 
payment from the domestic reverse hybrid entity to the related foreign 
interest holder shall be determined based on the appropriate rate of 
withholding that would be applicable to dividends paid by the domestic 
reverse hybrid entity to the related foreign interest holder under the 
U.S. treaty with the related foreign interest holder's jurisdiction had 
that jurisdiction viewed the domestic reverse hybrid entity as not 
fiscally transparent. Because any payment subject to the provisions of 
this special rule is treated as a dividend for all purposes of the Code 
and the applicable treaty, the domestic reverse hybrid entity will not 
be able to claim a deduction on the payment to the related foreign 
interest holder.
    The regulations provide an 80% ownership test to determine if the 
parties are related to one another and a special rule that treats 
accommodation parties as related foreign interest

[[Page 12447]]

holders. The foregoing rules also apply to recharacterize payments when 
more than one domestic reverse hybrid entity or other fiscally 
transparent entity is involved.
    The proposed regulations further provide that a taxpayer may not 
affirmatively use the rules of paragraph (d)(2) of this section if a 
principal purpose for using such rules is the avoidance of any tax 
imposed by the Code. Thus, with respect to such a taxpayer, the 
Commissioner may depart from the rules of this section and 
recharacterize (for all purposes of the Code) the arrangement in 
accordance with its form or its economic substance. The regulations 
further provide that, if a taxpayer enters into an arrangement the 
effect of which is to circumvent the principles of this paragraph 
(d)(2), the Commissioner may recharacterize (for all purposes of the 
Code) the arrangement in accordance with the principles of this 
paragraph (d)(2).
    Comments are requested on potential rules with respect to 
transaction when the domestic reverse hybrid entity is sold to 
unrelated parties who later receive distributions.

Proposed Effective Dates

    These proposed regulations apply to items of income paid by a 
domestic reverse hybrid entity on or after the date these regulations 
are published as final regulations in the Federal Register with respect 
to amounts received by the domestic reverse hybrid entity on or after 
the date these regulations are published as final regulations in the 
Federal Register. No inference is intended as to the treatment of 
transactions entered into prior to the date of applicability of the 
final regulations.

Special Analysis

    It has been determined that this notice of proposed rulemaking 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 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. Pursuant to section 7805(f) of the Code, this notice 
of proposed rulemaking will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury Department specifically request comments on 
the clarity of the proposed regulations and how they can be made easier 
to understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for June 26, 2001, at 10 a.m. 
in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Because of access restriction, visitors will not 
be admitted beyond the Internal Revenue Building lobby more than 15 
minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by May 29, 2001, and submit an outline of the 
topics to be discussed and the time to be devoted to each topic 
(preferably a signed original and eight (8) copies) by June 5, 2001.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Shawn R. Pringle of 
the Office of the Associate Chief Counsel (International). However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirments.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. In Sec. 1.894-1, paragraph (d)(2)(ii) is revised and 
paragraphs (d)(2)(iii) and (d)(2)(iv) are added to read as follows:


Sec. 1.894-1  Income affected by treaty.

* * * * *
    (d) * * *
    (2) * * *
    (ii) Payments by domestic reverse hybrid entities--(A) General 
rule. Except as otherwise provided in paragraph (d)(2)(ii)(B) of this 
section, an item of income paid by a domestic reverse hybrid entity to 
an interest holder in such entity shall have the character of such item 
of income under U.S. law and shall be considered to be derived by the 
interest holder, provided the interest holder is not fiscally 
transparent in its jurisdiction, as defined in paragraph (d)(3)(iii) of 
this section, with respect to the item of income. In determining 
whether the interest holder is fiscally transparent with respect to the 
item of income under this paragraph (d)(2)(ii)(A), the determination 
under paragraph (d)(3)(ii) of this section shall be made based on the 
treatment that would have resulted had the item of income been paid by 
an entity that is not fiscally transparent under the laws of the 
interest holder's jurisdiction with respect to any item of income.
    (B) Payment made to related foreign interest holder--(1) General 
rule. If--
    (i) A domestic entity makes a payment to a related domestic reverse 
hybrid entity that is treated as a dividend under either the laws of 
the United States or the laws of the jurisdiction of a related foreign 
interest holder in the domestic reverse hybrid entity, and under the 
laws of the jurisdiction of the related foreign interest holder in the 
domestic reverse hybrid entity, the related foreign interest holder is 
treated as deriving its proportionate share of the payment under the 
principles of paragraph (d)(1) of this section; and
    (ii) The domestic reverse hybrid entity makes a payment of a type 
that is deductible for U.S. tax purposes to the related foreign 
interest holder and for which a reduction in the U.S. withholding tax 
rate would be allowed under paragraph (d)(2)(ii)(A) of this section but 
for this paragraph (d)(2)(ii)(B); then
    (iii) To the extent the amount of the payment described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section does not exceed the sum 
of the portion of the payment described in paragraph 
(d)(2)(ii)(B)(1)(i) of this section treated as derived by the related 
foreign interest holder and the portion of any other prior payments 
described in paragraph (d)(2)(ii)(B)(1)(i) of this section treated as 
derived by the related foreign interest holder, the amount of the 
payment described in (d)(2)(ii)(B)(1)(ii) of this section will be 
treated for all purposes

[[Page 12448]]

of the Internal Revenue Code and the applicable income tax treaty as a 
dividend, and the tax to be withheld from the payment described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section shall be determined 
based on the appropriate rate of withholding that would be applicable 
to dividends paid from the domestic reverse hybrid entity to the 
related foreign interest holder under the U.S. treaty with the related 
foreign interest holder's jurisdiction had that jurisdiction viewed the 
domestic reverse hybrid entity as not fiscally transparent; and
    (iv) For purposes of determining the amount to be recharacterized 
under paragraph (d)(2)(ii)(B)(1)(iii) of this section, the portion of 
the payments described in paragraph (d)(2)(ii)(B)(1)(i) of this section 
treated as derived by the related foreign interest holder shall be 
reduced by the amount of any prior actual dividend payments made by the 
domestic reverse hybrid entity to the related foreign interest holder 
and by the amount of any payments from the domestic reverse hybrid 
entity to the related foreign interest holder previously rechacterized 
under paragraph (d)(2)(ii)(B)(1)(iii) of this section.
    (2) Tiered entities. The principles of this paragraph (d)(2)(ii)(B) 
shall also apply to payments referred to in this paragraph 
(d)(2)(ii)(B) made among related entities when there is more than one 
domestic reverse hybrid entity or other fiscally transparent entities 
involved.
    (3) Definition of related. Related shall mean any entity satisfying 
the ownership requirements of section 267(b) or 707(b)(1), except that 
80 percent shall be substituted for 50 percent. For purposes of 
determining whether a person is related to another person, the 
constructive ownership rules of section 318 shall apply, and the 
attribution rules of section 267(c) also shall apply to the extent they 
attribute ownership to persons to whom section 318 does not attribute 
ownership. If a person enters into a transaction (or series of 
transactions) with the domestic reverse hybrid entity, its related 
interest holders, or its related entities, and the effect of the 
transaction (or series of transaction) is to avoid the principles of 
this paragraph (d)(2)(ii)(B), then that person shall be treated as 
related to the domestic reverse hybrid entity for purposes of this 
section.
    (C) Commissioner's discretion. The Commissioner may, as the 
Commissioner determines to be appropriate, recharacterize for all 
purposes of the Internal Revenue Code all or part of any transaction 
(or series of transactions) between related parties if the effect of 
the transaction (or series of transactions) is to avoid the principles 
of this paragraph (d)(2).
    (iii) Examples. The rules of this paragraph (d)(2) are illustrated 
by the following examples:

    Example 1. Treatment of payment by unrelated entity to domestic 
reverse hybrid entity. (i) Facts. Entity A is a domestic reverse 
hybrid entity, as defined in paragraph (d)(2)(i) of this section, 
with respect to the U.S. source dividends it receives from B, a 
domestic corporation to which A is not related, within the meaning 
of paragraph (d)(2)(ii)(B)(3) of this section. A's 85-percent 
shareholder FC is a corporation organized under the laws of Country 
X, which has an income tax treaty in effect with the United States. 
Under Country X law, FC is not fiscally transparent with respect to 
the dividend, as defined in paragraph (d)(3)(ii) of this section. In 
year 1, A receives a $100 of dividend income from B. Under Country X 
law, FC is treated as deriving $85 of the $100 dividend payment 
received by A. The applicable rate of tax on dividends under the 
U.S.-Country X income tax treaty is 5 percent with respect to a 10-
percent or more corporate shareholder.
    (ii) Analysis. Under paragraph (d)(2)(i) of this section, the 
U.S.-Country X income tax treaty does not apply to the dividend 
income received by A because the income is paid by B, a domestic 
corporation, to A, another domestic corporation. A remains fully 
taxable under the U.S. tax laws as a domestic corporation with 
regard to that item of income. Further, pursuant to paragraph 
(d)(2)(i) of this section, notwithstanding the fact that under the 
laws of Country X A is treated as fiscally transparent with respect 
to the dividend income, FC may not claim a reduced rate of taxation 
on its share of the U.S. source dividend income received by A.
    Example 2. Treatment of payment by domestic reverse hybrid 
entity to related foreign interest holder involving unrelated party. 
(i) Facts. The facts are the same as in Example 1. Both the United 
States and Country X characterize the payment by B in year 1 as a 
dividend. In addition, in year 2, A makes a payment of $25 to FC 
that is characterized under U.S. tax laws as an interest payment to 
FC on a loan from FC to A. Under the U.S.-Country X income tax 
treaty, the rate of tax on interest is zero. Under Country X laws, 
had the interest been paid by an entity that is not fiscally 
transparent under Country X's laws with respect to any item of 
income, FC would not be fiscally transparent as defined in paragraph 
(d)(2)(ii) of this section with respect to the interest.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100 payment from B to A. With respect to the $25 
payment from A to FC, paragraph (d)(2)(ii)(B) of this section will 
not apply because, although FC is related to A, A is not related to 
the payor of the dividend income it received. Under paragraph 
(d)(2)(ii)(A) of this section, the $25 interest income paid from A 
to FC in year 2 will be characterized under U.S. law as interest . 
Accordingly, in year 2, FC may obtain the reduced rate of 
withholding applicable to interest under the U.S.-Country X income 
tax treaty, assuming all other requirements for claiming treaty 
benefits are met.
    Example 3. Treatment of payment by domestic reverse hybrid 
entity to related foreign interest holder. (i) Facts. The facts are 
the same as in Example 2, except the $100 dividend income received 
by A in year 1 is from A's wholly owned subsidiary S.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100 dividend payment from S to A. However, the $25 
interest payment in year 2 by A to FC will be treated as a dividend 
for all purposes of the Internal Revenue Code and the U.S.-Country X 
income tax treaty because $25 does not exceed FC's share of the $100 
dividend payment made by S to A ($85). Since FC is not fiscally 
transparent with respect to the payment as determined under 
paragraph (d)(2)(ii)(A) of this section, FC will be entitled to 
obtain the reduced rate applicable to dividends under the U.S.-
Country X income tax treaty with respect to the $25 payment. Because 
the $25 payment in year 2 is recharacterized as a dividend for all 
purposes of the Internal Revenue Code and the U.S.-Country X income 
tax treaty, A would not be entitled to an interest deduction with 
respect to that payment and FC would not be entitled to claim the 
reduced rate of withholding applicable to interest.

    (iv) Effective date. This paragraph (d)(2) applies to items of 
income paid by a domestic reverse hybrid entity on or after the date 
these regulations are published as final regulations in the Federal 
Register with respect to amounts received by the domestic reverse 
hybrid entity on or after the date these regulations are published as 
final regulations in the Federal Register.
* * * * *

Robert E Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-1687 Filed 2-26-01; 8:45 am]
BILLING CODE 4830-01-P