IRS provides roadmap for hybrids
Foreign tax planning often consists of trying to exploit differences in definitions between the US and a foreign country.
For example, there are benefits to capitalizing a foreign subsidiary through hybrid instruments that look like debt to the local country but are equity for US tax purposes. (The benefit is one can reduce foreign taxes in the foreign country and, at the same time, defer taxes in the US.) However, this is not always easy to do. The US and the other country must define “debt” differently. There is also the problem what the instrument says. The US will usually hold a taxpayer to whatever form he chose for an instrument. Thus, if the instrument uses debt terminology, the taxpayer will have to have strong proof to overcome the presumption that he should be stuck with his own label.
Earlier this year, the IRS announced that it would no longer issue advance rulings in transactions where a company is claiming inconsistent tax treatment between the US and a foreign country with which the US has a tax treaty. Taxpayers will have to take their chances on audit.
With that background, it was surprising to see the IRS approve a hybrid transaction in a private ruling to a US manufacturing company recently. The IRS just made the ruling public. (A private ruling is not binding on the IRS except for the taxpayer to whom it was issued.)
The US manufacturing company has a subsidiary in country X. Country X gives tax credits to encourage foreign investment. The US manufacturer wants to count the retained earnings it leaves in the subsidiary as new investment in country X. Unfortunately, tax credits are not available unless the money leaves the country and is reinvested from offshore.
Consequently, the manufacturer entered into what the IRS said was a “binding commitment” with its subsidiary in which the manufacturer committed to vote all its shares at the next shareholder meeting to cause the subsidiary to pay out the retained earnings as a dividend, and it also committed to return the dividend, net of withholding taxes, to the subsidiary as an additional capital investment.
The manufacturing company went to the IRS just before carrying out the plan. The subsidiary planned to pay the dividend into a bank account in country X in the name of the US manufacturer. The bank would then transfer it to the bank account of the subsidiary per advance instruction. No additional shares would be issued by the subsidiary in exchange for the capital contribution.
The IRS said there will be no dividend in the US.
It essentially collapsed the steps and treated them as if nothing had happened.
The taxpayer got hybrid treatment — a dividend for foreign tax purposes but a nonevent in the US. The IRS was no doubt swayed by the fact that all the steps had been wired in advance.
Foreign tax planners have a certain number of tools in their tool boxes. The ruling serves as a reminder to consider prewiring and binding commitments to give a transaction or instrument a different look in the US.
By Keith Martin