Notional Interest Deductions & Hybrid Dividends
U.S. multinational enterprises that own subsidiaries in countries such as Belgium, Italy, Portugal, Switzerland, and Cyprus that permit notional interest deductions for local country income tax purposes should consider the effect of U.S. anti-hybrid dividend rules.
The Organisation for Economic Co-operation and Development (OECD), an international organization that has been on the leading edge of addressing worldwide international taxation policies, confronted the issue of hybrid mismatch arrangements in Action 2 of its Base Erosion and Profit Shifting (BEPS) initiative. At the heart of the issue is the goal of preventing double nontaxation of cross-border income achieved through the use of hybrid instruments, hybrid branches, and other hybrid arrangements. For example, if an expense is considered an interest or royalty expense on a debt instrument or intangible property for the payer’s local country tax purposes but the recipient treats the income as a dividend for its local tax purposes as a payment received on an equity instrument, the BEPS Action 2 report expects either the payer’s jurisdiction to disallow a deduction for the hybrid expense or the recipient’s jurisdiction to disallow a participation exemption with respect to the hybrid dividend income so as to prevent income from being untaxed in both the payer’s and recipient’s jurisdictions.
U.S. Congress addressed some of the concerns of the BEPS Action 2 report by enacting anti-hybrid mismatch rules under Internal Revenue Code Sections 245A(e) and 267A as part of the Tax Cuts and Jobs Act. Section 245A generally permits a 100 percent dividend received deduction for dividends a U.S. C corporation receives from a specified foreign corporation, but §245A(e) disallows a §245A dividend received deduction for hybrid dividends. Section 267A disallows a deduction for any disqualified related-party amount paid or accrued involving a hybrid transaction or a hybrid entity.
Deemed payments such as notional interest deductions (NID) are outside the scope of the BEPS Action 2 report because the deduction does not relate to an actual expense. But the Action 2 report notes that NID should be considered further in the context of the Action 2 report’s hybrid recommendations.
The concept of NID aims to achieve tax neutrality between debt and equity financing. NID rules generally provide a deduction for a company funded with equity equal to an approximate amount of interest the company would have paid to a lender had it been funded with debt instead of equity. Countries that have NID regimes include Belgium, Italy, Portugal, Switzerland (only available on a cantonal level), Cyprus, Malta, and Lichtenstein.
Because NID is computed in reference to a company’s equity, the U.S. Department of the Treasury (Treasury) and IRS view it as a deduction for dividends the foreign company pays or will pay in the future to its shareholders. Thus, to prevent double nontaxation of income, Treasury regulations disallow a §245A dividend received deduction to the extent the foreign company has claimed NID or similar equity-based deductions on its foreign income tax returns.
The mechanism by which the §245A(e) regulations disallow a §245A dividend received deduction for hybrid dividends received by a domestic corporation is through the maintenance of a hybrid deduction account. A domestic corporation’s hybrid deduction account with respect to a specified foreign corporation is increased for hybrid deductions such as NID permitted on the foreign corporation’s foreign income tax return. The hybrid deduction account is reduced for hybrid dividends the specified foreign corporation pays to its shareholder. A domestic corporation shareholder also reduces its hybrid deduction account with respect to a controlled foreign corporation (CFC) to the extent of its adjusted Subpart F and adjusted Global Intangible Low-Taxed Income (GILTI) from the CFC and for §956 inclusions.
For example, assume the following facts:
- A U.S. corporation incorporates a wholly owned Italian subsidiary during the year and funds the subsidiary with an amount that both U.S. and Italian tax rules treat as equity.
- The Italian CFC has no Subpart F income for the year, but the U.S. corporation has a $500,000 §951A GILTI inclusion from the Italian CFC during the year, resulting in an incremental U.S. tax liability of $2,100 on the Italian CFC GILTI income after factoring in the §78 gross-up, 50 percent GILTI deduction under §250(a)(1)(B), 80 percent deemed paid foreign tax credit under §960(d), and §904 foreign tax credit limit.
- The Italian CFC’s §951A(c) gross tested income equals 100 percent of its overall gross income for the year.
- The Italian CFC pays a distribution of €450,000 out of its current earnings and profits to the U.S. corporation during the year.
- The Italian CFC takes advantage of the Italian NID regime by claiming an allowance for corporate equity (ACE) deduction on its initial Italian federal income tax return of €20,000.
- The average USD-to-EUR exchange rate for the year is 1 to 0.85.
The U.S. corporation increases its Italian CFC hybrid deduction account by the €20,000 ACE deduction claimed on the CFC’s Italian tax return and reduces its hybrid deduction account by an adjusted GILTI income amount of €8,500 for a net increase in the hybrid deduction account of €11,500.
The €8,500 adjusted GILTI income is calculated as the lesser of two items: (1) the euro translated amount of the U.S. corporation’s U.S. incremental tax imposed on the GILTI income grossed up at the 21 percent U.S. corporate tax rate ($2,100 incremental U.S. tax / 21 percent U.S. tax rate = $10,000 × 0.85 fx rate = €8,500) or (2) the €20,000 current-year ACE deduction multiplied by the 100 percent rate of gross tested income over overall gross income.
The €450,000 distribution consists of the following components:
- €425,000 nontaxable distribution of §959(c)(2) GILTI previously taxed earnings and profits ($500,000 GILTI income × 0.85 fx rate = €425,000)
- €11,500 hybrid dividend that is taxable to the U.S. corporation and is ineligible for the §245A dividend received deduction (lesser of the €11,500 hybrid deduction account or the €25,000 distribution of §959(c)(3) nonpreviously taxed earnings and profits)
- €13,500 dividend that is eligible for the §245A dividend received deduction
No foreign tax credit or deduction is allowed for any Italian dividend withholding tax imposed on the €11,500 hybrid dividend or the €13,500 §245A-eligible dividend pursuant to §§245A(d) and (e). The U.S. corporation reduces its hybrid deduction account by the €11,500 hybrid dividend resulting in zero ending balance to carry over to next year.
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