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Cross-border tax arbitrage--the characterization of a single thing in contrasting ways in two (or more) jurisdictions--is central to U.S. international tax planning today. Hybrid entities play a major role. Indeed, hybrid entities have become so ubiquitous that, in many structures, their use has become wholly unremarkable, at least among the tax-planning community.

Notwithstanding the widespread use and acceptance of hybrid entities among tax planners, in some circles (chiefly on Capitol Hill, in certain parts of academia, and in the tax press) the cross-border tax arbitrage permitted may smack of at least the potential for abuse. For the last decade, however, the IRS and Treasury have been careful in picking their way through the myriad of issues raised by the use of hybrid entities, prohibiting benefits from the use of hybrid entities only selectively, issue by issue (see, e.g., §894(c) and the regulations thereunder, and the proposed regulations dealing with the use of reverse hybrids to split foreign taxes from associated earnings and profits).

This approach seems correct. Where the use of hybrid entities does no damage to the collection of U.S. tax and the principles on which U.S. taxation is based, and where no mutual treaty-based promises or assumptions are sacrificed, why should the Treasury and the IRS, or the U.S. Congress, find the use of hybrid entities objectionable? Indeed, if hybrids can be used to reduce foreign taxes without compromising U.S. principles or treaty obligations (or the assumptions on which they are based), it is to the U.S. government's advantage to allow such use of hybrids, since that use will increase residual U.S. tax on repatriations (through the reduction of foreign tax credits). In the post-January 20, 2009, possible scramble for revenues, hybrid entities should not generally be a target.

Illustration 1

For example, in Illustration 1, US wishes to repatriate earnings from its foreign subsidiary, FC. US would prefer, however, to avoid any FC country dividend withholding tax. FC's country of residence, unfortunately, has no treaty with the United States (or its treaty with the United States doesn't eliminate withholding tax on dividends).

Instead of having FC pay it a dividend, US forms FC2, checks the box to disregard FC2, then sells the FC shares to FC2 for FC2's note. FC distributes its cash and earnings to FC2; FC2 uses the cash to repay its note to US.

For U.S. tax purposes the sale should be disregarded, as should the FC2 note and its repayment. For foreign tax purposes, however, the FC-to-FC2 distribution may be eliminated in the foreign country's consolidation or group relief regime, while the cash distribution from FC2 to US is considered a non-taxable event--the repayment of loan principal. The result is a repatriation of FC's cash without any foreign withholding tax. The timing of the debt push-down and the subsequent repayment may, of course, implicate foreign anti-abuse rules, but in many jurisdictions such a structure may be viable if structured properly.

Illustration 2

Hybrid entities can also be used to avoid foreign tax thin capitalization restrictions by increasing equity in the foreign group without adverse U.S. tax consequences. In Illustration 2, US would like to loan to FC to reduce the FC consolidated income tax and for other pertinent business reasons. FC's country's thin cap rules, however, may prevent the FC group from deducting the interest paid on such a loan because there may be insufficient equity in the FC group.

Instead, US checks the box on FC to make it a disregarded entity (DE). US then: (1) contributes additional equity to FC; (2) FC uses that cash to purchase preferred shares from US2; (3) US2 distributes or loans the cash back to US. For U.S. tax purposes, this can be accomplished with no tax effect. For foreign tax purposes, however, US's equity in FC has been increased by the amount of cash that went around the circle. Additional equity in FC, under many countries' thin cap regimes, raises the thin cap limits for related-party borrowing by FC for foreign tax purposes.

Illustration 3

A foreign group can also finance its non-U.S. subsidiaries using a hybrid entity to achieve foreign interest deductions with no U.S. or foreign lender income inclusion. As illustrated in Illustration 3, FC forms US, a U.S. hybrid entity, and capitalizes it with equity. US then lends its capital to FC2 and FC3 (or drops notes with respect to loans previously made to FC2 and FC3), foreign subsidiaries of FC in countries with zero withholding tax on interest.

The interest paid by FC2 and FC3 should generally be deductible in each entity's respective home country. That interest should not be taxable in the United States, since US is a DE, unless US conducts a U.S. trade or business. Nor should it be taxable in FC's country since that country views the interest as having been received by US, a corporate entity. If FC2 and FC3 have domestic withholding tax on interest, however, there is a question regarding whether US will be considered a resident of the United States and eligible for treaty benefits.

In each of these three foreign tax reduction structures it appears that no U.S. tax technical rule or policy concern is being subverted. Therefore, it is difficult to see why the IRS, Treasury, or Congress should react negatively to any of the three.

This commentary also will appear in the April 11, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Isenbergh, 900 T.M., Foundations of U.S. International Taxation, and in Tax Practice Series, see ¶7110, Foreign Income Taxation -- General Principles.