Industry Director Directive #1 on International Hybrid Instrument Transactions
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D. C. 20224
Large and Mid-Size Division
LMSB Control No. 04-0407-035
Impacted IRM 4.51.5
June 15, 2007
|MEMORANDUM FOR||INDUSTRY DIRECTORS AND
TECHNICAL GUIDANCE PREFILING
DIRECTOR, INTERNATONAL COMPLIANCE STRATEGY AND POLICY
|FROM:||Walter Harris /s/ Walter L. Harris
Director, Field Specialists
|SUBJECT:||Tier I Issue – International Hybrid Instrument Transactions Directive #1|
This Directive is intended to (i) provide further field direction on a Tier I issue relating to Section 385 abuse and (ii) remind the field that these are mandatory examination issues requiring that any resolution of the issue must be approved by the International Hybrid Instrument Transactions Issue Management Team. The core issue is whether these cross-border financing transactions entered into between related parties should be treated as debt or equity under U.S. federal tax law, including Section 385.
International Hybrid Instrument Transactions are cross-border financing arrangements in which the taxpayer takes different positions in its treatment of the transaction as debt or equity for U.S. and foreign tax purposes. There are two types of International Hybrid Transactions: (a) Debt in U.S. Transactions and (b) Equity in U.S. Transactions. When a taxpayer treats a cross-border financing arrangement as debt for U.S. purposes and equity for foreign tax purposes (“Debt in U.S. Transactions”), the taxpayer can achieve the following benefits: (1) interest expense deductions in the U.S.; (2) reduced withholding rates on interest payments under an applicable treaty (circumventing the “reverse hybrid regulations under § 894(c)); (3) non-recognition of interest income in the foreign jurisdiction; and (4) foreign tax credits in the foreign jurisdiction. Generic Legal Advice Memorandum (“GLAM”) AM 2006-001, released by the Office of Chief Counsel on September 26, 2006 discusses a typical Equity in U.S. Transaction. The Glam concluded that a promissory note and a forward purchase agreement should be considered together with the result that they are treated as a single instrument and considered equity for U.S. tax purposes. The U.S. taxpayer may claim the income received is non taxable under Section 305(a) even though the related payer treats the payment as an interest expense for foreign tax purposes. Other Equity in U.S. Transactions includes fact patterns where the ownership of a related off-shore entity is considered equity for U.S. tax purposes and debt for foreign tax purposes.
UIL: 385.04-07 Hybrid Instruments (Equity) and 385.04-08 Hybrid Instruments (Debt)
Planning and Examination Guidance:
The Debt in U.S Transactions is engaged in by foreign controlled U.S. taxpayers to deduct interest in the U.S. without incurring a U.S. or foreign tax on the earnings. The transactions generally involve the use of hybrid entities and various stock purchase agreements. There are two types of transactions (1) Transactions treated by the taxpayer as repurchase agreements (examiners should request copies of the forward purchase agreement and the guarantee agreement) and (2) Transactions involving subscription agreements (examiners should request copies of the agreement or the share purchase agreement). Examiners may also find a Form 8886, Reportable Transaction Disclosure Statement attached to the U.S. tax return, describing the transaction and the tax impact. The filing of this form, by the taxpayer, is strictly voluntary.
Typical Equity in U.S. Transactions described in the GLAM is engaged in by a U.S. corporation that wholly owns both a Disregarded Entity (DE) and a Controlled Foreign Corporation (CFC). The DE borrows funds from an unrelated party, and loans the funds to the CFC in exchange for a promissory note. The promissory note is treated as debt for foreign tax purposes. For U.S. tax purposes the promissory note and a forward purchase agreement between the U.S. Corporation and the CFC are treated as one instrument and considered equity rather than debt.
Planning and Examination Risk Analysis:
The field should review and challenge all arguments by taxpayers who claim that these transactions are debt or equity for U.S. tax purposes. The analysis is very fact specific and requires a careful examination of the documents executed in the transaction. The assistance of an International Examiner and a Financial Products Specialist should be made, through the Specialist Referral System. Equity in U.S. Transactions, cases under examination with a substantially similar fact pattern as described in the GLAM should be confirmed that they follow the conclusions in the GLAM. In determining whether a transaction is substantially similar to those in the GLAM, the team should consult with local counsel and the IMT. If it is confirmed that the transaction is substantially similar to that in the GLAM, the Team should follow the conclusions in the GLAM. However, if the factual pattern and/or the conclusion of the transaction fall outside of the GLAM, then the Team should challenge the transaction’s purported results and ensure appropriate communication and collaboration with local Counsel as well as the IMT. Teams should also consult with the IMT to determine whether other cross-border transactions involving section 385 fall under this directive.
Information Document Requests should be prepared by an International Examiner and Financial Products Specialist. Pro-forma IDRs will be developed and shared with the field, as soon as it becomes available.
Questions regarding the development of either the equity or debt issue should be referred to International Technical Advisor.
This Directive is not an official pronouncement of law or the position of the Service and can not be used, or cited, or relied upon as such.
cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Division Counsel, LMSB
Director, Performance, Quality and Audit Assistance