[Federal Register Volume 67, Number 113 (Wednesday, June 12, 2002)]
[Rules and Regulations]
[Pages 40157-40162]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-14506]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8999]
RIN 1545-AY13


Treaty Guidance Regarding Payments With Respect to Domestic 
Reverse Hybrid Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 894 
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 (domestic reverse hybrid entities). The 
regulations affect the determination of tax treaty benefits with 
respect to U.S. source income of foreign persons.

DATES: Effective Date: These regulations are effective June 12, 2002.
    Applicability Date: These regulations are applicable to items of 
income paid by a domestic reverse hybrid entity on or after June 12, 
2002 with respect to amounts received by the domestic reverse hybrid 
entity on or after June 12, 2002.

FOR FURTHER INFORMATION CONTACT: Elizabeth U. Karzon at (202) 622-3880 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On February 27, 2001, the IRS and Treasury published a notice of 
proposed rulemaking (REG-107101-00) in the Federal Register (66 FR 
12445) under section 894 relating to whether payments made by domestic 
reverse hybrid entities to their interest holders are eligible for 
benefits under income tax treaties. A limited number of comments 
responding to the notice of proposed rulemaking were received. After 
consideration of these comments, the proposed regulations are adopted 
as final regulations as revised by this Treasury decision.

Explanation of Provisions

I. General

    These final section 894 regulations clarify the availability of 
treaty benefits on payments made by a domestic reverse hybrid entity 
(DRH) to its interest holders. A DRH is a U.S. entity that the United 
States treats as non-fiscally transparent (e.g., as a corporation), but 
the interest holder's country treats as fiscally transparent (e.g., as 
a partnership or branch). These regulations are the final piece of 
guidance associated with section 894 regulations finalized on July 3, 
2000 (TD 8889; 65 FR 40993) (the ``2000 regulations''), that generally 
address the availability of treaty benefits on items of U.S. source 
income paid to hybrid entities (i.e., entities treated as fiscally 
transparent by one jurisdiction but non-fiscally transparent by 
another).
    The preamble to the 2000 regulations noted that the IRS and 
Treasury had learned that non-U.S. multinationals were establishing DRH 
structures in the United States to manipulate the U.S. tax treaty 
network to obtain tax-advantaged financing. The IRS and Treasury 
notified the public in that preamble that they intended to issue 
regulations to address this situation.
    Proposed regulations were issued on February 27, 2001. The proposed 
regulations provided guidance with respect to two distinct issues 
involving domestic reverse hybrid entities. First, to resolve a 
technical question raised by commentators regarding the application of 
the 2000 regulations, the proposed regulations clarified that a payment 
by a domestic reverse hybrid entity to a foreign interest holder may be 
eligible for treaty benefits. No comments were received on this portion 
of the proposed regulations, and the rule in the proposed regulations 
is accordingly adopted without change in these final regulations.
    The proposed regulations also addressed certain structures 
involving domestic reverse hybrid entities that Treasury and the IRS 
believed represented the use of such entities to obtain inappropriate 
treaty benefits. The comments received in response to this portion of 
the proposed regulations generally confirmed the need for regulations 
to address the use of DRH structures by non-U.S. companies. One 
commentator wrote in its comment that ``regulations addressing the DRH 
structure are appropriate.'' The commentator noted that DRH structures 
are ``relatively uncommon'' with the exception of their use by highly 
sophisticated non-U.S. multinational groups to procure acquisition 
financing at a tax-advantaged rate vis-a-vis their U.S. competitors.
    Several commentators expressed concern that the approach taken in 
the proposed DRH regulations might erode the simplicity achieved by the 
section 7701 entity classification rules, known as the Check-the-Box 
(CTB) regulations. The IRS and Treasury have carefully considered this 
comment, but continue to believe that the approach in these final 
regulations is appropriate. The regulations only apply to a DRH 
structure established by a group of taxpayers related to each other by 
80% common ownership. This high ownership requirement minimizes the 
possibility that a taxpayer might inadvertently establish such a 
structure. In addition, the comments confirm that DRH structures remain 
``relatively uncommon.'' Thus, any loss of the simplification benefits 
of the CTB regulations also will be relatively uncommon.
    One commentator suggested that, rather than adopt the approach in 
the regulations, the IRS and Treasury should pursue an approach under 
section 1503(d) to directly address structures similar to, and 
potentially including, the DRH that rely on hybrid entity structures to 
deduct the same

[[Page 40158]]

interest expense in two jurisdictions (commonly called a ``double dip'' 
of interest deductions) to achieve tax-advantaged financing. The 
commentator expressed the view that the real concern of the IRS and 
Treasury should be this double dip on deductions, rather than the tax 
treaty manipulation present in DRH structures.
    Treasury and the IRS agree that a re-examination of the rules of 
section 1503(d) and the policies underlying those rules may be 
appropriate. Such a re-examination will require substantial and careful 
analysis with respect to the interaction of U.S. and foreign law in a 
variety of contexts and is therefore beyond the scope of these 
regulations, which, as noted above, focus on the use of DRH structures 
to obtain inappropriate treaty benefits.
    In this regard, the commentator misconstrues the concern of the IRS 
and Treasury with respect to the issues associated with the use of DRH 
structures. Treasury and the IRS are concerned that DRH structures are 
being established by related parties to manipulate differences in U.S. 
and foreign entity classification rules to reduce, through 
inappropriate use of an income tax treaty, the amount of tax imposed on 
items of income paid by domestic corporations to related foreign 
companies. The overall effect of these transactions, if respected, 
would be (1) a deduction under U.S. law for the ``outbound'' payment of 
an item of income, (2) the reduction or elimination of U.S. withholding 
tax on that item of income under an applicable treaty, and (3) the 
imposition of little or no tax by the treaty partner on the item of 
income. This result is inconsistent with the expectation of the United 
States and its treaty partners that treaties should be used to reduce 
or eliminate double taxation of income. The legislative history of 
section 894(c) supports this analysis. Congress specifically expressed 
its concern about the use of income tax treaties to manipulate the 
inconsistencies between U.S. and foreign tax laws to obtain similar 
benefits. 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 adopted by these regulations also is 
consistent with the U.S. view that contracting states to an income tax 
treaty may adopt provisions in their domestic laws to prevent 
inappropriate use of the treaty. See, e.g., the Treasury Department 
Technical Explanation to Article 22 ( Limitation on Benefits) of the 
1996 United States Model Income Tax Convention. See also Commentaries 
to Article 1 of the 2000 OECD Model Tax Convention on Income and 
Capital; S. Rep. No. 445, 100th Cong. 2d Sess. 322-23 (1988).
    Another commentator questioned Treasury's authority for issuing the 
regulations, arguing that the recharacterization of an interest payment 
as a dividend payment may contravene the definition of interest 
contained in various U.S. treaties. The IRS and Treasury have concluded 
that the regulations are consistent with U.S. law, including U.S. 
treaties. These final regulations are issued under the authority of 
sections 894(a), 894(c), 7805 and 7701(l). Further, as noted above, 
contracting states to an income tax treaty may adopt provisions in 
their domestic laws to counter inappropriate uses of the treaty. Id.

II. Comments and Changes to Sec. 1.894-1(d)(2)(ii)(B)(1): Payment Made 
to Related Foreign Interest Holder

    Section 1.894-1(d)(2)(ii)(B)(1) of the proposed regulations 
provided a special rule that was generally targeted at payments made by 
a domestic reverse hybrid entity to a foreign parent of the domestic 
reverse hybrid entity. This rule would apply if: (1) A domestic 
subsidiary made a payment to a domestic reverse hybrid entity, the 
payment was considered to be a dividend either under the laws of the 
United States or under the laws of the jurisdiction of the foreign 
parent of the domestic reverse hybrid entity, and the domestic reverse 
hybrid entity was treated as a fiscally transparent, or ``pass-
through,'' entity under the foreign parent's laws; and (2) the domestic 
reverse hybrid entity made a deductible payment to the foreign parent 
that otherwise would qualify for a treaty-based reduction in U.S. 
withholding tax. Under these circumstances, the proposed regulations 
provided that the payment by the domestic reverse hybrid entity would 
be treated as a dividend for all purposes of the Internal Revenue Code 
and the applicable income tax treaty, but only to the extent of the 
foreign parent's proportionate share of the prior dividend payments 
made to the domestic reverse hybrid entity by the domestic subsidiary.
    Commentators recommended the inclusion of a tax avoidance purpose 
test in the final regulations. As part of this approach, commentators 
suggested consideration of several factors, including the ability of 
the domestic reverse hybrid entity to satisfy the debt independent of 
dividends or payments from the domestic entity, and the amount of time 
between the time the related foreign interest holder, the domestic 
reverse hybrid entity, and the domestic entity became related persons 
and the incurrence of the inter-company debt. This recommendation was 
not adopted. These regulations are intended to provide objective rules 
regarding eligibility for treaty benefits on certain items of U.S. 
source income paid by domestic reverse hybrid entities.
    Commentators requested clarification that paragraph (d)(2)(ii)(B) 
does not apply to payments made by a domestic reverse hybrid entity 
that would not be subject to withholding tax without regard to a 
treaty. Commentators are correct in reading the regulations to provide 
that paragraph (d)(2)(ii)(B) will not apply if the payment made by the 
domestic reverse hybrid entity is exempt from withholding tax under the 
Internal Revenue Code. Commentators also requested clarification that 
the regulations apply only to payments received by the domestic reverse 
hybrid entity while it is related to both the domestic entity and the 
related foreign interest holder, and to payments made by the domestic 
reverse hybrid entity while it is related to the related foreign 
interest holder. The text of these regulations also confirms this 
result. Accordingly, no changes to the regulations were considered 
necessary on either of these points.
    As a general matter, commentators questioned whether paragraph 
(d)(2)(ii)(B)(1) of the regulations applies to a situation in which the 
dividend withholding rate under the applicable income tax treaty is 
lower than the withholding rate for interest under the treaty. The 
regulations do not make the recharacterization of the deductible 
payment dependent on the withholding rates in the applicable income tax 
treaty. Therefore, if the requirements of the regulations are met, the 
regulations will apply regardless of whether the dividend withholding 
rate is higher than the withholding rate for interest or other 
deductible payments in the applicable income tax treaty. An example to 
this effect has been added to the final regulations.

III. Comments and Changes to Sec. 1.894-1(d)(2)(ii)(B)(3): Definition 
of Related

    Paragraph (d)(2)(ii)(B)(3) of the proposed regulations defined the 
term related for purposes of determining whether a domestic entity made 
a dividend payment to a related domestic reverse hybrid entity, and for 
purposes of determining whether a domestic reverse hybrid entity made a 
payment to a related foreign interest holder. The ownership 
requirements set forth in section 267(b) or 707(b)(1), the

[[Page 40159]]

constructive ownership rules of sections 318, and attribution rules of 
section 267(c) were used solely to determine whether an entity was 
``related'' for purposes of paragraph (d)(2)(ii)(B); and not to 
determine if the entity was an interest holder.
    Commentators consequently have questioned whether corporations that 
do not own any stock directly in the domestic reverse hybrid entity, 
but are related to the domestic reverse hybrid entity within the 
meaning of paragraph (d)(2)(ii)(B)(3), can be interest holders, and, 
therefore, related foreign interest holders for purposes of paragraph 
(d)(2)(ii)(B). For example, commentators questioned whether the 
regulations apply if a domestic reverse hybrid entity, which has 
received a dividend payment from a related domestic entity, makes an 
interest payment to a foreign sister corporation of the domestic 
reverse hybrid entity which is not itself a shareholder in the domestic 
reverse hybrid entity. Commentators believe that the application of the 
regulations to a foreign sister corporation should depend on whether 
that corporation is part of a ``consolidated group'' under the laws of 
the jurisdiction of the foreign parent.
    The IRS and Treasury generally agree with this position. Paragraph 
(d)(2)(ii)(B)(ii) of the final regulations provides that a payment to a 
person, wherever organized, the income and losses of which are 
available, under the laws of the jurisdiction of the related foreign 
interest holder, to offset the income and losses of a related foreign 
interest holder, will be treated as a payment to a related foreign 
interest holder, and the regulations will apply. Examples have been 
added to the final regulations illustrating these principles.
    Paragraph (d)(2)(ii)(B)(3) of the proposed regulations also 
contained a special rule that would treat certain accommodation parties 
as related foreign interest holders. Pursuant to the rule in the 
proposed regulations, if a person entered into a transaction with a 
domestic reverse hybrid entity, its related interest holder, or other 
related entity, and the effect of the transaction was to avoid the 
principles of these regulations, then that person would be treated as 
related to the domestic reverse hybrid entity for purposes of this 
section. Commentators expressed concern that this language could 
encompass legitimate dealings with unrelated third parties. For 
example, an unrelated foreign bank that makes a loan to a domestic 
reverse hybrid entity and receives interest payments under the loan 
could be treated as related to the domestic reverse hybrid entity under 
paragraph (d)(2)(ii)(B)(3). In recognition of the fact that the special 
rule in paragraph (d)(2)(ii)(B)(3) was potentially overbroad and 
created uncertainty as to its application, the rule was deleted.

IV. Comments and Changes to Sec. 1.894-1(d)(2)(ii)(C): Commissioner's 
discretion.

    Paragraph (d)(2)(ii)(C) of the proposed regulations provided the 
Commissioner with the authority to 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 
was to avoid the principles of paragraph (d)(2)(ii)(B). Commentators 
also questioned the scope of this provision and requested the inclusion 
of examples of situations in which the Commissioner would not exercise 
his discretion and situations in which the Commissioner may exercise 
his discretion. Commentators were concerned that this provision would 
allow the Commissioner to apply the regulations to legitimate, non-
abusive transactions involving domestic reverse hybrid entities.
    In response to these comments, and in recognition of the 
potentially overbroad reach of the proposed provision, paragraph 
(d)(2)(ii)(C) has been modified in the final regulations to narrow its 
scope and clarify the circumstances under which the provision will 
apply. Thus, under paragraph (d)(2)(ii)(C)(1) of the final regulations 
(which applies to transactions involving related parties), the 
Commissioner has authority to recharacterize a transaction only if the 
following conditions are met: (1) A deductible payment is made to a 
person who is related, as that term is defined in paragraph 
(d)(2)(ii)(B)(3), to the domestic reverse hybrid entity (but is not 
otherwise described in paragraph (d)(2)(ii)(B)(1)(ii)); and (2) that 
payment is made in connection with one or more transactions the effect 
of which is to avoid the application of paragraph (d)(2)(ii)(B). If 
paragraph (d)(2)(ii)(C)(1) applies, the Commissioner is authorized to 
treat the deductible payment as if it were received directly by the 
related foreign interest holder in the domestic reverse hybrid entity.
    In addition, paragraph (d)(2)(ii)(C)(2) of the final regulations 
(which applies to transactions involving an unrelated ``middleman'') 
provides that the Commissioner may treat a deductible payment made by a 
domestic reverse hybrid entity to an unrelated person as being made 
directly to a related foreign interest holder if: (1) The unrelated 
person (or other person (whether related or not) which receives a 
payment in a series of transactions that includes a transaction 
involving such unrelated person) makes a payment to the related foreign 
interest holder (or other person described in paragraph 
(d)(2)(ii)(B)(1)(ii)); (2) the payment to the unrelated person and the 
payment to the related foreign interest holder are made in connection 
with a series of transactions which constitute a financing arrangement, 
as defined in Sec. 1.881-3(a)(2)(i); and (3) the transactions have the 
effect of avoiding the application of paragraph (d)(2)(ii)(B) of this 
section. An example has been added to illustrate the principles 
contained in this revised paragraph (d)(2)(ii)(C)(2).
    To the extent the Commissioner recharacterizes a deductible payment 
as a distribution within the meaning of section 301(a) under this 
paragraph (d)(2)(ii)(C), the payment will be treated as such for all 
purposes of the Internal Revenue Code and the applicable income tax 
treaty.

Special Analysis

    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 Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and, because 
these regulations do not impose a collection of information requirement 
on small entities, 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 Internal Revenue Code, the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Karen A. Rennie-
Quarrie 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 requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

[[Page 40160]]

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, paragraphs (d)(2)(ii), and (d)(2)(iii) are 
added and paragraph (d)(6) is revised 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 or to a person, wherever organized, the income and 
losses of which are available, under the laws of the jurisdiction of 
the related foreign interest holder, to offset the income and losses of 
the related foreign interest holder, and for which a reduction in U.S. 
withholding tax would be allowed under an applicable income tax treaty; 
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 of the Internal Revenue Code and any 
applicable income tax treaty as a distribution within the meaning of 
section 301(a) of the Internal Revenue Code, and the tax to be withheld 
from the payment described in paragraph (d)(2)(ii)(B)(1)(ii) of this 
section (assuming the payment is a dividend under section 301(c)(1) of 
the Internal Revenue Code) 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 
in accordance with the principles of paragraph (d)(2)(ii)(A) of this 
section.
    (2) Determining amount to be recharacterized under paragraph 
(d)(2)(ii)(B)(1)(iii). For purposes of determining the amount to be 
recharacterized under paragraph (d)(2)(ii)(B)(1)(iii) of this section, 
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 shall be increased by the portion of the payment derived by any 
other person described in paragraph (d)(2)(ii)(B)(1)(ii), and shall be 
reduced by the amount of any prior section 301(c) distributions made by 
the domestic reverse hybrid entity to the related foreign interest 
holder or any other person described in paragraph (d)(2)(ii)(B)(1)(ii) 
and by the amount of any payments from the domestic reverse hybrid 
entity previously recharacterized under paragraph (d)(2)(ii)(B)(1)(iii) 
of this section.
    (3) Tiered entities. The principles of this paragraph (d)(2)(ii)(B) 
also shall 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 entity 
involved.
     (4) Definition of related. For purposes of this section, a person 
shall be treated as related to a domestic reverse hybrid entity if it 
is related by reason of the ownership requirements of section 267(b) or 
707(b)(1), except that the language ``at least 80 percent'' applies 
instead of ``more than 50 percent,'' where applicable. For purposes of 
determining whether a person is related by reason of the ownership 
requirements of section 267(b) or 707(b)(1), 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.
    (C) Payments to persons not described in paragraph 
(d)(2)(ii)(B)(1)(ii)--(1) Related persons. The Commissioner may treat a 
payment by a domestic reverse hybrid entity to a related person (who is 
neither the related foreign interest holder nor otherwise described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section), in whole or in part, 
as being made to a related foreign interest holder for purposes of 
applying paragraph (d)(2)(ii)(B) of this section, if--
    (i) The payment to the related person is of a type that is 
deductible by the domestic reverse hybrid entity; and
    (ii) The payment is made in connection with one or more 
transactions the effect of which is to avoid the application of 
paragraph (d)(2)(ii)(B) of this section.
    (2) Unrelated persons. The Commissioner may treat a payment by a 
domestic reverse hybrid entity to an unrelated person, in whole or in 
part, as being made to a related foreign interest holder for purposes 
of applying paragraph (d)(2)(ii)(B) of this section, if--
    (i) The payment to the unrelated person is of a type that is 
deductible by the domestic reverse hybrid entity;
    (ii) The unrelated person (or other person (whether related or not) 
which receives a payment in a series of transactions that includes a 
transaction involving such unrelated person) makes a payment to the 
related foreign interest holder (or other person described in paragraph 
(d)(2)(ii)(B)(1)(ii));
    (iii) The foregoing payments are made in connection with a series 
of transactions which constitute a financing arrangement, as defined in 
Sec. 1.881-3(a)(2)(i); and
    (iv) The transactions have the effect of avoiding the application 
of paragraph (d)(2)(ii)(B) of this section.
    (iii) Examples. The rules of this paragraph (d)(2) are illustrated 
by the following examples:

    Example 1. Dividend paid 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)(4) of

[[Page 40161]]

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. A's remaining 15-percent 
shareholder is an unrelated domestic corporation. 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 $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 payment is made 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 A is 
treated as fiscally transparent with respect to the dividend income 
under the laws of Country X, FC may not claim a reduced rate of 
taxation on its share of the U.S. source dividend income received by 
A.
    Example 2. Interest paid by domestic reverse hybrid entity to 
related foreign interest holder where dividend is paid by unrelated 
entity. (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 the Internal Revenue Code as interest 
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 a related foreign interest holder 
in A, A is not related to B, the payor of the dividend income it 
received. Under paragraph (d)(2)(ii)(A) of this section, the $25 of 
interest paid by A to FC in year 2 is characterized under U.S. law 
as interest. Accordingly, in year 2, A is entitled to an interest 
deduction with respect to the $25 interest payment from A to FC, and 
FC is entitled to 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.  Interest paid by domestic reverse hybrid entity to 
related foreign interest holder where dividend is paid by a related 
entity. (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 is entitled to 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 is 
not entitled to an interest deduction with respect to that payment 
and FC is not entitled to claim the reduced rate of withholding 
applicable to interest.
    Example 4. Definition of related foreign interest holder. (i) 
Facts. The facts are the same as in Example 3, except that A has two 
50-percent shareholders, FC1 and FC2. In year 2, A makes an interest 
payment of $25 to both FC1 and FC2. FC1 is a corporation organized 
under the laws of Country X, which has an income tax treaty in 
effect with the United States. FC2 is a corporation organized under 
the laws of Country Y, which also has an income tax treaty in effect 
with the United States. FP owns 100-percent of both FC1 and FC2, and 
is organized under the laws of Country X. Under Country X law, FC1 
is not fiscally transparent with respect to the dividend, as defined 
in paragraph (d)(3)(ii) of this section. Under Country X law, FC1 is 
treated as deriving $50 of the $100 dividend payment received by A 
because A is fiscally transparent under the laws of Country X, as 
determined under paragraph (d)(3)(iii) of this section. 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. Under Country Y law, FC2 is not treated as 
deriving any of the $100 dividend payment received by A because, 
under the laws of Country Y, A is not a fiscally transparent entity.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100 dividend payment from S to A. With respect to 
the $25 payment in year 2 by A to FC1, the payment will be treated 
as a dividend for all purposes of the Internal Revenue Code and the 
U.S.-Country X income tax treaty because FC1 is a related foreign 
interest holder as determined under paragraph (d)(2)(ii)(B)(4) of 
this section, and because $25 does not exceed FC1's share of the 
dividend payment made by S to A ($50). FC1 is a related foreign 
interest holder because FC1 is treated as owning the stock of A 
owned by FC2 under section 267(b)(3). Since FC1 is not fiscally 
transparent with respect to the payment as determined under 
paragraph (d)(2)(ii)(A) of this section, FC1 is entitled to the 5-
percent 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 is not entitled to an interest deduction with respect to 
that payment. Even though FC2 is also a related foreign interest 
holder, the $25 interest payment by A to FC2 in year 2 is not 
recharacterized because A is not fiscally transparent under the laws 
of Country Y, and FC2 is not treated as deriving any of the $100 
dividend payment received by A. Thus, the U.S.-Country Y income tax 
treaty is not implicated.
    Example 5. Higher treaty withholding rate on dividends. (i) 
Facts. The facts are the same as in Example 3, except that under the 
U.S.-Country X income tax treaty, the rate of tax on interest is 10-
percent and the rate of tax on dividends is 5-percent.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100 dividend payment from S to A. The analysis is 
the same as in Example 3 with respect to the $25 interest payment in 
year 2 from A to FC.
    Example 6. Foreign sister corporation the income and losses of 
which may offset the income and losses of related foreign interest 
holder. (i) Facts. The facts are the same as Example 3, except that 
in year 2, A makes the interest payment of $25 to FS, a subsidiary 
of FC also organized in Country X. Under the laws of Country X, FS 
is not fiscally transparent with respect to the interest payment, 
and the income and losses of FS may be used to offset the income and 
losses of FC.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100 dividend payment from S to A. With respect to 
the $25 interest payment from A to FS in year 2, FS is a person 
described in paragraph (d)(2)(ii)(B)(1)(ii) of this section because 
the income and losses of FS may be used under the laws of Country X 
to offset the income and losses of FC, the related foreign interest 
holder that derived its proportionate share of the payment from S to 
A. Therefore, paragraph (d)(2)(ii)(B) of this section applies, and 
the $25 interest payment in year 2 by A to FS is treated as a 
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty because the $25 payment does not exceed 
FC's share of the $100 dividend payment made by S to A ($85). Since 
FS is not fiscally transparent with respect to the payment as 
determined under paragraph (d)(2)(ii)(A) of this section, FS is 
entitled to obtain the 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 is not entitled to an interest deduction with respect 
to the payment and FS is not entitled to claim the reduced rate of 
withholding applicable to interest under the U.S.-Country X income 
tax treaty.
    Example 7. Interest paid by domestic reverse hybrid entity to 
unrelated foreign bank. (i) Facts. The facts are the same as in 
Example 3, except that in year 2, A makes the interest payment of 
$25 to FB, a Country Y unrelated foreign bank, on a loan from FB to 
A.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100

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dividend payment from S to A. With respect to the payment from A to 
FB, paragraph (d)(2)(ii)(B) of this section will not apply because, 
although A is related to S, the payor of the dividend income it 
received, A is not related to FB under paragraph (d)(2)(ii)(B)(4) of 
this section. Under paragraph (d)(2)(ii)(A) of this section, the $25 
interest payment made from A to FB in year 2 is characterized as 
interest under the Internal Revenue Code.
    Example 8. Interest paid by domestic reverse hybrid to an 
unrelated entity pursuant to a financing arrangement. (i) Facts. The 
facts are the same as in Example 7, except that in year 3, FB makes 
an interest payment of $25 to FC on a deposit made by FC with FB.
    (ii) Analysis. The analysis is the same as in Example 1 with 
respect to the $100 dividend payment from S to A. With respect to 
the $25 payment from A to FB in year 2, because the payment is made 
in connection with a transaction that consititutes a financing 
arrangement within the meaning of paragraph (d)(2)(ii)(C)(2) of this 
section, the payment may be treated by the Commissioner as being 
made directly to FC. If the Commissioner disregards FB, then the 
analysis is the same as in Example 3 with respect to the $25 
interest payment in year 2 from A to FC.
    Example 9. Royalty paid by related entity to domestic reverse 
hybrid entity. (i) Facts. The facts are the same as in Example 3, 
except the $100 income received by A from S in year 1 is a royalty 
payment under both the laws of the United States and the laws of 
Country X. The royalty rate under the treaty is 10 percent and the 
interest rate is 0 percent.
    (ii) Analysis. The analysis as to the royalty payment from S to 
A is the same as in Example 1 with respect to the $100 dividend 
payment from S to A. With respect to the $25 payment from A to FC, 
paragraph (d)(2)(ii)(B) of this section will not apply because the 
payment from S to A is not treated as a dividend under the Internal 
Revenue Code or the laws of Country X. Under paragraph (d)(2)(ii)(A) 
of this section, the $25 of interest paid by A to FC in year 2 is 
characterized as interest under the Internal Revenue Code. 
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.

    (6) Effective dates. This paragraph (d) applies to items of income 
paid on or after June 30, 2000, except paragraphs (d)(2)(ii) and 
(d)(2)(iii) of this section apply to items of income paid by a domestic 
reverse hybrid entity on or after June 12, 2002 with respect to amounts 
received by the domestic reverse hybrid entity on or after June 12, 
2002.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: June 3, 2002.
Pamela F. Olson,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 02-14506 Filed 6-11-02; 8:45 am]
BILLING CODE 4830-01-P