U.S. tax planners often refer to “hybrid entities” and “reverse hybrid entities.” This blog entry briefly discusses the meaning of these terms.
From a U.S. tax perspective, a hybrid entity is an entity that is “fiscally transparent” for U.S. tax purposes but not fiscally transparent for foreign tax purposes. In general, an entity is fiscally transparent if the entity’s current year profits are currently taxable to the owners of the entity, regardless of whether the entity made any distributions to its owners during that year. (See Treas. Reg. § 1.894-1(d)(3)(ii) and (iii) for a more extensive definition.)
Partnerships are typically fiscally transparent entities. Corporations are typically not fiscally transparent entities. Limited liability companies and various types of foreign entities may or may not be fiscally transparent.
A reverse hybrid entity is the “reverse” of a hybrid entity in that the entity is fiscally transparent for foreign tax purposes but not fiscally transparent for U.S. tax purposes. Entities that are treated the same for U.S. and foreign tax purposes are not “hybrid” entities.
Unfortunately, these terms ( Hybrid Entities and Reverse Hybrid Entities) are not intuitive. A hybrid entity is an entity that is “fiscally transparent” for U.S. tax purposes but not fiscally transparent for foreign tax purposes, and a reverse hybrid entity is the “reverse” of a hybrid entity in that the entity is fiscally transparent for foreign tax purposes but not fiscally transparent for U.S. tax purposes.
The I.R.S. recently published Notice 2010-62, which deals with Pre-2011 “splitter arrangements” under the new foreign tax credit splitter rules of Code § 909. Splitter arrangements can occur with reverse hybrid entity structures as well as with hybrid instruments.
New Hybrid Instrument Terminology
Interestingly, the Notice creates a new (to me, at least) terminology for hybrid instruments. The Notice refers to an instrument that is treated as equity for U.S. tax purposes and as debt for foreign tax purposes as a “US Equity Hybrid Instrument” (or a “US Equity HI”). Further, the Notice refers to an instrument that is treated as debt for U.S. tax purposes and as equity for foreign tax purposes as a “US Debt Hybrid Instrument” (or a “US Debt HI”).
I really like this new terminology. It is very intuitive. It is easy to remember that a US Debt HI is debt for U.S. tax purposes. If it is a hybrid, therefore, it must be treated as equity for foreign tax purposes. I commend the I.R.S. for this simple but helpful innovation.
Application to Entities
This terminology can also be applied to hybrid entities. For instance, a hybrid entity could be called a “US Fiscally Transparent Hybrid Entity” or “US FT HE” for short. Intuitively, if the entity is fiscally transparent for U.S. tax purposes, then it must be non-fiscally transparent for foreign tax purposes.
Similarly, a reverse hybrid entity could be called a “US Non-Fiscally Transparent Hybrid Entity” or “US NFT HE” for short. The Notice does discuss reverse hybrid entities, but unfortunately, the author of the Notice didn’t suggest the new terminology for entities.
For my charts, I use the triangle pointing upwards to represent a US FT HE and a triangle pointing downwards to represent a US NFT HE. I do not use ovals, as many tax practitioners do, to represent disregarded entities. My reason for avoiding ovals is that it is often unclear whether a nominee shareholder of a foreign entity should be treated as a separate owner, creating a partnership, or whether the nominee should be disregarded under substance principles, resulting in a disregarded entity (see e.g., Rev. Proc. 2010-32).
Two recent cases have considered the availability of double taxation relief in the UK in circumstances involving US hybrid entities.
In Swift UK v HMRC1, the Tribunal considered whether a US LLC was an opaque or transparent entity for UK tax purposes and therefore whether a UK resident member of the LLC could obtain double tax relief for US tax paid on his share of the profits. The Tribunal held, contradicting HMRC's established practice, that the LLC was transparent for UK tax purposes as it is more akin to a partnership than a company. This will be a concern, for example, to UK taxpayers with direct or indirect interests in LLCs.
In Bayfine UK v HMRC2, a claim was successfully made to credit US taxes against a UK company's tax liability where such taxes arose on the same income in the company's US parent as a result of the UK company being treated as transparent for US tax purposes following a "check the box" election. The case looked at the analysis of the US tax treaty and unilateral tax relief under UK law for a circumstance which had not been envisaged by the treaty or UK legislation.
HMRC general practice follows the principles in Memec plc v CIR3. Pursuant to this case, in determining whether an entity is transparent or opaque and HMRC will follow the guidelines set out in its manuals and previous Tax Bulletins.
In particular, the following matters should be considered under the relevant local commercial law:
Does the foreign entity have a legal existence separate from that of the persons who have an interest in it?
Does the entity issue share capital or something else, which serves the same function as share capital?