American Bar Association Section of Taxation

American Bar Association Section of Taxation Chair Sam K. Kaywood, Jr. Alston & Bird LLP 1201 West Peachtree Street Atlanta, GA 30309-3424 Tel: 404.881.7481 Fax: 404.881.7777 skaywood@alston.com Use of Hybrids in Inbound Investment Transactions Panelists David G. Shapiro Dechert LLP Cira Centre / 2929 Arch Street Philadelphia, PA 19104 Tel: 215.994.2456 Fax: 215.994.2222 david.shapiro@dechert.com Jordi Domínguez GARRIGUES 410 Park Avenue, Suite 510 New York, NY 10022 Tel: 212.751.9233 Fax: 212.355.3594 jordi.dominguez@garrigues.com Alan I. Appel Bryan Cave LLP 1290 Avenue of the Americas New York, NY 10104 Tel: 212.541-2292 Fax: 212.261-9865 aiappel@bryancave.com

Treatment of Hybrids* *Prepared by David G. Shapiro and Stanley C. Ruchelman. 12212576-v1

Withholding: Basic Principles • Section 1441: withholding from payments to nonresident alien individuals and foreign partnerships • Section 1442: withholding from payments to foreign corporations (tracks rules of section 1441) • Required withholding: 30% of payments of interest, dividends, rents, royalties, compensation, or any other “fixed or determinable annual or periodic income” (FDAP) • Rate of withholding may be reduced by treaty 12212576-v1

Withholding: Basic Requirements • Treasury regulations under § 1441 establish procedures for all withholding under §§ 1441 and 1442 • Withholding agent responsible for obtaining documentation establishing reduced withholding rate or exemption from withholding, and must be able to reliably associate documentation with payee • In absence of documentation, withholding agent must determine whether payee is US or foreign. If US, subject to backup withholding; if foreign, subject to 30% withholding • Special rules apply to intermediaries who receive payments but are not the ultimate beneficiaries of payments 12212576-v1

Withholding Certificates • W-9: US citizen or resident • W-8BEN: Foreign person (individual or corporation) who is the beneficial owner of the payment • Treaty benefits must be claimed on this form • W-8ECI: Foreign person who is the beneficial owner of the payment, and payment is effectively connected with a US trade or business • W-8EXP: Foreign government or international organization exempt from tax and withholding • W-8IMY: Foreign intermediaries and most pass-through entities (e.g. partnerships) 12212576-v1

Withholding: Pass-ThroughEntities (In General) • Foreign partnership treated as pass-through; look to ultimate beneficiaries. • Non-withholding partnership: W-8IMY accompanied by W-8BENs of ultimate beneficiaries, together with statement showing allocation of payment among ultimate beneficiaries • W-8BENs and allocation statement not required for “withholding foreign partnership” • Other financial intermediaries submit W-8IMY, with or without W-8BENs (depending on whether they are “qualified intermediaries”) 12212576-v1

Withholding: Pass-ThroughEntities (In General) • Exceptions: hybrid entities and reverse hybrid entities • May be able to claim treaty benefits, but not based solely on residence of their owners 12212576-v1

Hybrid Entities: Illustration of the Issue ForeignCorporation Dividends Equity US LLC Interest Debt U.S.Corporation 12212576-v1

Hybrid Entity Issue • LLC viewed as pass-through for US purposes, corporation for foreign purposes • Under old US rules: • Interest would be treated as paid to foreign parent; withholding at treaty rate • Distribution to foreign parent intended to be tax-exempt (or subject to reduced tax) in foreign jurisdiction • Net effect: reduced-rate withholding was the only tax paid on the upstream payments 12212576-v1

Hybrid Entities: Code § 894(c) and Treas. Reg. § 1.894-1(d) • § 894(c) enacted in 1997 to address use of hybrid entities to inappropriately claim treaty benefits • § 894 regulations for hybrid entities finalized in 2000 • Foreign person not entitled to treaty benefits if income is derived by entity treated as partnership or otherwise fiscally transparent [for US purposes] but treated as nontransparent for foreign purpose • Exceptions under regulations for a hybrid that is: • A resident of a treaty jurisdiction, treated as an entity, and subject to tax on its worldwide income, or • Treated as fiscally transparent for purposes of a member that is resident in a treaty jurisdiction 12212576-v1

Hybrid Entities: Code § 894(c) and Treas. Reg. § 1.894-1(d) • For an entity to be treated as fiscally transparent: • Interest holders must take into account their share of all income on a current basis, whether or not distributed • Income must retain the character it would have if the income were realized directly by the interest holder • In general, each item of income must be separately taken into account unless separate accounting would not produce a higher tax than aggregation of all items • In other words, the entity must be treated like a partnership, not like a CFC, under local law principles 12212576-v1

RCo2 YCo U.S. Source FDAP Income RCo HybridEntityRegulations: Example 1 • RCo is treated as entity in R, transparent in US. RCo 2 and YCo are both treated as entities by US. • R-US treaty; no Y-US treaty • Holding: RCo is entitled to treaty benefits 12212576-v1

RCo2 YCo U.S. Source FDAP Income RCo Hybrid Entity Regulations: Example 2 • RCo is treated as entity in R; transparent in US and Y • R and Y both have treaties with US; Y-US treaty provides greater benefits • Holding: RCo is entitled to treaty benefits; YCo is entitled to greater treaty benefits for its share of income 12212576-v1

XCo YCo U.S. Source FDAP Income VCo Hybrid Entity Regulations: Example 3 • VCo treated as an entity in X, treated as transparent in Y • No V-US treaty; both X and Y have treaties with US • Holding: YCo entitled to treaty benefits; XCo is not. 12212576-v1

XCo YCo Treaties with U.S. U.S. Source FDAP Income LLC Hybrid Entity Regulations: Example 4 • LLC treated as entity in X • LLC treated as transparent in Y and US • Holding: YCO is entitled to treaty benefits; XCO is not entitled to benefits because LLC is not transparent in X; LLC must withhold 30% tax on XCO share of income. 12212576-v1

XCo YCo Treaties with U.S. LLC U.S. Source FDAP Income Hybrid Entity Regulations: Example 5 • LLC treated as entity in X and XCO is taxed on profits of LLC under the CFC rules in X • LLC treated as transparent in Y and US • Holding: YCo is entitled to treaty benefits; XCo is not entitled to benefits because LLC is not transparent in X; LLC must withhold 30% tax on XCO share of income. 12212576-v1

XCo2 U.S. Source FDAP Income XCo Hybrid Entities Regulations: Example 6 • XCo is transparent in X, treated as corporation in US • XCo2 is treated as corporation in both X and us • Holding: XCo2 is entitled to treaty benefits; it is taxed on income of XCo as if earned directly 12212576-v1

Treatment of Hybrids in Spain* *Prepared by Jordi Dominguez. 12212576-v1

Summary • Foreign entity classification • “Forward” hybrid entities - LLC • Tax treatment of foreign transparent entities • Applicability of Tax Treaties to hybrid or reverse hybrid entities 12212576-v1

I. Foreign Entity Classification • Based on Spanish tax regulations, “any entity established abroad whose legal nature is the same as or similar to flow-throw entities established in accordance with Spanish law” will be regarded as transparent. • Main features of Spanish transparent entities: • Absence of legal personality (with one exception: civil partnership –sociedad civil-) • No separate property • Unlimited liability 12212576-v1

I. Foreign Entity Classification • Access to results by partners • Limited term • Restriction on right to transfer interest in the entity • Management carried out by its members rather than by a separate corporate body • Irrespective of the tax classification of the entity by the country where the entity is established. • Several rulings issued by the Spanish General Directorate of Taxation: Dutch CCV, UK Limited Liability Partnership (no LLC) 12212576-v1

SP Company LLC* U.S.: FT SP: Non-FT LLC engaged in US business activities: connected income taxable in the US II. “Forward” Hybrid Entities - LLC • Taxation of income deferred until distributed by the LLC • Characterization of the income for Spanish tax purposes: dividend • Double Tax relief: • Exemption method: “subject to tax” test fulfilled, even if US taxes are paid by the partner and not the LLC • Alternatively, applicability of the credit method * Disregarded for US tax purposes

SP Company U.S.: FT SP: Non-FT LLC* LLC not taxable in the US Interest Foreign Company II. “Forward” Hybrid Entities - LLC • Taxation of income deferred until distributed by the LLC (provided that CFC rules are not applicable) • Characterization of the income for Spanish tax purposes: dividend • Double Tax relief: • Exemption method: not applicable, “subject to tax” test not fulfilled • Credit method: no juridical or economical double taxation *Disregarded for US tax purposes 12212576-v1

SP Partner FTE U.S.: FT SP: FT Income derived from the engagement in foreign business activities III. Tax Treatment of Foreign Transparent Entities • General principle: income attributed to the SP partner as obtained by the FTE • Classification of the income for tax purposes: same nature than the income obtained by the FTE • Applicable regulations depending on the partners of the FTE • Double Tax Relief: • Application of internal regulations or Tax Treaty 12212576-v1

U.S. Partner Foreign Partner U.S.: Non-FT Foreign: Non-FT LLC Interests SPAIN Source Country IV. Applicability of Tax Treaties to Hybrid or Reverse Hybrid Entities • Facts: LLC treated as a corporation for US and Foreign Partner tax purposes • Relevant treaty applicable: Spain - US Tax Treaty 12212576-v1

LLC IV. Applicability of Tax Treaties to Hybrid or Reverse Hybrid Entities • Facts: LLC treated as a partnership for US tax purposes • Treaty applicable: partners (Foreign partner only if taxation in its country of residence), irrespective of the consideration of the LLC as a corporation for Spanish tax purposes • Competent Authority Agreement between Spain and the USA: treaty applicable to the LLC provided that income is subject to tax as the income of a US resident U.S. Partner Foreign Partner U.S.: FT Interests SPAIN Source Country 12212576-v1

U.S. Partner U.S.: Non-FT Local: FT Interests SPAIN Source Country Foreign Entity IV. Applicability of Tax Treaties to Hybrid or Reverse Hybrid Entities • Facts: US treats Foreign Entity as a corporation, but treated as a disregarded entity in its country of incorporation • US – Spain Tax Treaty not applicable • FE – Spain Tax Treat not applicable 12212576-v1

U.S. Partner U.S.: FT Local: Non-FT Foreign Entity Interests SPAIN Source Country IV. Applicability of Tax Treaties to Hybrid or Reverse Hybrid Entities • Facts: US treats Foreign entity as a transparent entity, but treated as a corporation in its country of incorporation • Tax Treaty applicable: Spain and the country where the Foreign entity is resident, if any, and Spain – US Tax Treaty (most favorable) 12212576-v1

Domestic Reverse Hybrids* *Prepared by Sam K. Kaywood, Jr. 12212576-v1

FIH (Country Y) Loan Interest DRH Dividends U.S. OPCO Domestic Reverse HybridsBasic Structure • U.S. • DRH = C Corp for U.S. tax purposes, but flow-thru for foreign. • Interest deductible by DRH for U.S. purposes, subject to §163(j). • Treaty reduction or exemption of 30% withholding tax. • Foreign • Dividends paid by U.S. Opco exempt under participation exemption type regime. • Interest received by FIE is ignored. 12212576-v1

Domestic Reverse HybridsDRH Regulations IF (1) Domestic Entity makes a payment to a “related” DRH • Treated as a dividend either under U.S. or foreign law • Related FIH treated as receiving its share of the dividend (2) DRH makes a payment • To a related FIH (or certain consolidated related persons) • Deductible for U.S. tax purposes 12212576-v1

Domestic Reverse HybridsDRH Regulations THEN • The payment by DRH to FIH (described in (2)) is recharacterized as a non-deductible §301 distribution (a dividend up to E&P) • Up to the dividend paid to DRH (described in (1)) • Apply appropriate treaty rate to dividend • Likely to be higher withholding since most treaties exempt interest and royalties from withholding • Reduce amount to be recharacterized by any actual dividends during that taxable year 12212576-v1

Unrelateds FIH 79% 21% DRH 79% 21% U.S. OPCO Domestic Reverse Hybrids“Related” • Related = 80% or more of vote and value • DRH not related to FIH • U.S. Opco not related to DRH • No payments counted in DRH test 12212576-v1

FIH (Country Y) Loan Interest DRH Distribution U.S. Opco (LLC) Domestic Reverse HybridsHybrid U.S. Opco • U.S. Opco disregarded for U.S. tax purposes • DRH recharacterization rule still applies • Payment by domestic entity to DRH treated as dividend under U.S. or foreign law 12212576-v1

Year 1 2 3 DividendsReceived by DRH $50 $50 $50 DistributionPaid by DRH 0 0 $50 Current YearRecharacterizableIncome $50 $60 $20 Interest &RoyaltiesPaid $40 $40 $40 Interest &RoyaltiesRecharacterized $40 $40 $20 RecharacterizableIncomeCarry Forward $10 $20 0 Domestic Reverse HybridsMechanics of Recharacterization Test Recharacterize deductible payments to the extent of: + Dividends under U.S. or foreign law received by DRH + Prior dividends (U.S. or foreign) received by DRH -- Prior distributions paid by DRH -- Previously recharacterized payments 12212576-v1

Year 1 2 3 DividendsReceived 0 0 $120 DividendsPaid 0 0 0 Current YearRecharacterizableIncome 0 0 $120 DeductiblePayments $40 $40 $40 PaymentsRecharacterized 0 0 $40 RecharacterizableIncomeCarry Forward 0 0 $80 Domestic Reverse HybridsMechanics of Recharacterization Test • Timing the dividends to be received • No anti-abuse rule appears to apply 12212576-v1

Domestic Reverse HybridsInteraction With Other Provisions Natural Dovetail With No Deduction Until Payment Provisions • §267(a)(3) – Payments to related foreign persons • §163(e)(1) – Payments of OID to related foreign persons Provisions Deferring or Disallowing Deduction Take Priority • §163(j) – Anti-earnings stripping • §263A(f) – Capitalized interest • 163(f)(1) – Registration required obligations • §279(a) – Acquisition indebtedness 12212576-v1

FIH (Country Y) Interest DRH Foreign Sub (Consolidated) (Country Y) Loan U.S. Opco Domestic Reverse HybridsForeign Consolidation Structures • For foreign purposes, interest paid by DRH deducted by FIH • Loss by FIH offsets income of Foreign Sub under consolidation regime • DRH recharacterization rule applies even though payment is made to a non-interest holder • Reg. §1.894-1(d)(2)(ii)(B)(1)(ii). 12212576-v1

FIH (Country Y) DRH 1 Interest Dividends U.S. Opco DRH 2 Domestic Reverse HybridsTiered Structures • DRH 1 receive payments but doesn’t make payments. • Recharacterization test applies when payments made among more than one DRH or other hybrid entities. • Reg. § 1.894-1(d)(2)(ii)(B)(3). 12212576-v1

FIH (Country Y) Loss Assets Interest DRH Loan Foreign Sub (Consolidated) (Country Y) U.S. Opco Domestic Reverse HybridsRelated Person Anti-Abuse Rule • Foreign Sub not consolidated with FIH or not in County Y. • FIH transfers built-in loss assets to Foreign Sub to shelter interest income. • Payment of interest “made in connection with one or more transactions the effect of which is to avoid the application of the [recharacterization rule].” Reg. §1.894-1(d)(2)(C)(1). • Anti-abuse rule likely to apply. 12212576-v1

FP (Country X) Interest FIH (Country X) DRH Dividend U.S. Opco Domestic Reverse HybridsRelated Person Anti-Abuse Rule • Payment of interest to non-interest holder - recharacterization rule doesn’t apply. • Does RP anti-abuse rule apply? If FP is taxed in County X, is there an “effect” of avoiding treaty abuse? 12212576-v1

FP (Country X) FIH1 (Country X) FIH2 (Country Y) Loan Interest Interest Interest DRH U.S. OPCO Domestic Reverse HybridsMultiple Foreign Interest Holders • County X treats DRH as fiscally transparent. • County Y does not treat DRH as fiscally transparent. • Test each FIH separately. • Payments to FIH1 subject to recharacterization. • Payment to FIH2 not subject to recharacterization. 12212576-v1

FIH (Country Y) Interest DRH Loan Dividend U.S. Opco Bank Domestic Reverse HybridsLoans From Third Parties • Interest payments not subject to recharacterization rule because bank is not a FIH and otherwise unrelated to DRH. • Reg. §1.894-1(d)(2)(iii) (Example 7). • Nothing prohibiting FIH from guaranteeing the loan. 12212576-v1

Sells Preferred Stock Foreign Investor $ Preferred U.S.Parent U.S. Sub Dividends/Interest Domestic Reverse HybridsSale/Repo Agreements • U.S. • U.S. Parent treated as borrowing money and pledging preferred stock in U.S. sub. • Dividends paid to Foreign Investor on preferred stock treated as paid to U.S. Parent, followed by U.S. Parent paying interest to Foreign Investor. 12212576-v1

Sells Preferred Stock Foreign Investor $ Preferred U.S.Parent U.S. Sub Dividends/Interest Domestic Reverse HybridsSale/Repo Agreements • Foreign • Dividends paid by U.S. Sub to Foreign Investor exempt under participation exemption regime. • Same effect as DRH. • Many foreign countries prohibit these arrangements. 12212576-v1

New Regulations Under §1446* *Prepared by Alan Appel and Michael J.A. Karlin. 12212576-v1

Agenda • Section 1446 background • A quick tour of the new regulations • How the regulations address issues under Section 1446, especially • Overwithholding • Tiered entities 12212576-v1

Section 1446 Background 12212576-v1

Collection of Tax on ECI • Two Methods: Estimated taxes and withholding • General Rule: Estimated taxes. Quarterly deposit of estimated taxes under section 6655 • Withholding applies in selected situations • Section 1446 – ECTI of foreign partners • Section 1445 – dispositions of US real property interests • Employer withholding on ECI wages • 30% withholding on independent personal services income which is ECI. Treas. Reg.  §1.1441-4 • Foreign person must still file 1040NR/1120F and pay balance of tax due 12212576-v1

Taxation of Foreign Partners • Section 875: Foreign partner is engaged in the US trade or business of any partnership, domestic or foreign – allocable share of partnership ECI is ECI to the partner • Cases provide tax treaty analogue to section 875: US permanent establishment of a partnership, domestic or foreign, is attributed to foreign partner. Donroyv. United States, 301 F.2d 200 (9th Cir. 1962); Unger v. Commissioner, TCM 1990-15 12212576-v1

American Bar Association Section of Taxation