Guidance under Subpart F Relating to
Partnerships & Branches.

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 301 [TD 8767] RIN 1545-
AWO7

TITLE: Guidance under Subpart F Relating to Partnerships and
Branches.

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary and final regulations.

SUMMARY: This document contains regulations relating to the
treatment under subpart F of certain payments involving branches of
a controlled foreign corporation (CFC) that are treated as separate
entities for foreign tax purposes or partnerships in which CFCs are
partners. These regulations are necessary to provide guidance on
transactions relating to such entities.

These regulations will affect United States shareholders of
controlled foreign corporations. The text of these temporary
regulations also serves as the text of the proposed regulations
published elsewhere in this issue of the Federal Register.

DATES: Effective date: These regulations are effective March 23,
1998.

Applicability date: For dates of applicability see ��1.904- 5T(o),
1.954-1T(c)(1)(i)(E), 1.954-2T(a)(5)(iii) and (a)(6)(ii),
1.954-9T(d) and 301.7701-3T(f) of these regulations.

FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840 (not a
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

I. In general In these temporary regulations and in proposed
regulations published elsewhere in this issue of the Federal
Register, the Treasury and IRS set forth a framework for dealing
with issues posed by the use of certain entities that are regarded
as fiscally transparent for purposes of U.S. tax law, with regard to
the application of subpart F of the Internal Revenue Code.

Subpart F was enacted by Congress to limit the deferral of U.S.
taxation of certain income earned outside the United States by
foreign corporations controlled by U.S. persons. Limited deferral
was retained after the enactment of subpart F to protect the
competitiveness of controlled foreign corporations (CFCs) doing
business overseas. See S. Rep. No. 1881, 87th Cong., 2d Sess. 78-80
(1962). This limited deferral furthers the objective of allowing a
CFC engaged in an active business, and located in a foreign country
for appropriate economic reasons, to compete in a similar tax
environment with non-U.S. owned corporations located in the same
country.

Conversely, one of the purposes of subpart F is to prevent CFCs from
converting active income that is not easily moveable and is earned
in a jurisdiction in which a business is located for non-tax
reasons, into passive, easily moveable income that is shifted to a
lower tax jurisdiction primarily for tax avoidance.

Moreover, when subpart F was first enacted it was realized that
related person transactions can be easily manipulated to reduce both
United States and foreign taxes. Consequently, in enacting subpart
F, Congress provided that transactions of CFCs that involve related
persons generally give rise to subpart F income with certain
enumerated exceptions.

Hybrid branches, which, by definition, are not regarded as fiscally
transparent under foreign law, are particularly well suited to the
type of tax avoidance described above. In light of the recent
proliferation of hybrid branches, Treasury and the IRS believe that
it is appropriate to consider the issues related to transactions
involving hybrid branches, or other hybrid entities, under subpart
F.

The use of partnerships that are fiscally transparent for U.S. tax
purposes raises additional issues in the context of subpart F that
are similar to those raised in connection with hybrid branches. Such
partnerships may or may not be fiscally transparent under foreign
law. (Other fiscally-transparent entities, such as grantor trusts,
will be the subject of guidance issued in conjunction with the
finalization of regulations under section 672(f).)

The entity classification regulations of ��301.7701-1 through
301.7701-3 (the check-the-box regulations) make entity
classification generally elective, in part so that taxpayers can
choose a tax status that is consistent with their business
objectives. This administrative provision was not intended to change
substantive law. Particularly in the international area, the ability
to more easily achieve fiscal transparency can lead to inappropriate
results under certain substantive international provisions of the
Code. Thus, the Treasury and the IRS believe that it is necessary to
provide additional guidance regarding the use of hybrid entities in
the international context. See preamble to TD 8697, 61 Fed. Reg.
66585 (December 18, 1996).

II. Hybrid Branches

As announced in Notice 98-11 (1998-6 I.R.B. 13), the Treasury and
the IRS understand that certain taxpayers are using arrangements
involving hybrid branches to circumvent the purposes of subpart F
(sections 951 through 964 of the Code). These arrangements generally
involve the use of deductible payments to reduce the taxable income
of a CFC under foreign law, thereby reducing that CFC's foreign tax
and, also under foreign law, the corresponding creation in another
entity of low-taxed, passive income of the type to which subpart F
was intended to apply.

Because of the structure of these arrangements, however, taxpayers
take the position that this income is not taxed under subpart F.
Treasury and the IRS have concluded that use of these hybrid branch
arrangements is contrary to the policies and rules of subpart F.

U.S. international tax policy seeks to balance the objective of
neutrality of taxation between domestic and foreign business
enterprises (seeking neither to encourage nor to discourage one over
the other), while keeping U.S. business competitive.

Subpart F strongly reflects and enforces that balance, while the
arrangements described above involving hybrid branches upset that
balance.

Explanation of Provisions

Under these temporary regulations, hybrid branch payments, as
defined in the regulations, between a CFC and its hybrid branch, or
between hybrid branches of the CFC may give rise to subpart F
income. When certain conditions are present, the non-subpart F
income of the CFC, in the amount of the hybrid branch payment, is
recharacterized as subpart F income of the CFC.

Those conditions include that: the hybrid branch payment reduces the
foreign tax of the payor; the hybrid branch payment would have been
foreign personal holding company income if made between separate
CFCs; and there is a disparity between the effective rate of tax on
the payment in the hands of the payee and the hypothetical rate of
tax that would have applied if the income had been taxed in the
hands of the payor. Treasury and the IRS are considering applying
similar principles with respect to the foreign base company services
income rules of section 954(e).

Comments are requested on this issue. Any regulations promulgated on
this issue will be prospective.

Policies underlying subpart F would also be avoided in certain non-
hybrid branch transactions that do not reduce the tax of the payor.
Treasury and the IRS invite comments on the extent to which rules
should be provided to address such transactions.

Any regulations promulgated on this issue will be prospective.

Comments are also requested regarding the application of these rules
to dividend and other equity distributions.

The temporary regulations make clear that the CFC and the hybrid
branch, or the hybrid branches, are treated as separate corporations
only to recharacterize non-subpart F income as subpart F income in
the amount of the hybrid branch payment, and to apply the tax
disparity rule of �1.954-9T(a)(5)(iv). For all other purposes (e.g.,
for purposes of the earnings and profits limitation of section 952),
a CFC and its hybrid branch, or hybrid branches, are not treated as
separate corporations.

The temporary regulations provide that the amount recharacterized as
subpart F income is the gross amount of the hybrid branch payment
limited by the amount of the CFC's earnings and profits attributable
to non-subpart F income. This amount is the excess of current
earnings and profits over subpart F income, determined after the
application of the rules of sections 954(b) and 952(c) and before
the application of these temporary regulations. To the extent that
the full amount required to be recharacterized under this provision
cannot be recharacterized because it exceeds earnings and profits
attributable to non-subpart F income, there is no requirement to
carry such amounts back or forward to another year.

For purposes of determining the amount of taxes deemed paid under
section 960, the amount of non-subpart F income recharacterized as
subpart F income is treated as attributable to income in separate
foreign tax credit baskets in proportion to the ratio of non-subpart
F income in each basket to the total amount of non-subpart F income
of the CFC for the taxable year.

The temporary regulations provide that, under certain circumstances,
the recharacterization rules will also apply to a CFC's
proportionate share of any hybrid branch payment made between a
partnership in which the CFC is a partner and a hybrid branch of the
partnership, or between hybrid branches of such a partnership. When
the partnership is treated as fiscally transparent by the CFC's
taxing jurisdiction, the recharacterization rules are applied by
treating the hybrid branch payment as if it had been made directly
between the CFC and the hybrid branch, or as though the hybrid
branches of the partnership had been hybrid branches of the CFC, as
applicable.

If the partnership is treated as a separate entity by the CFC's
taxing jurisdiction, the recharacterization rules are applied to the
partnership as if it were a CFC. Comments are requested on whether
the rule for such non-fiscally transparent partnerships should be
relaxed in the case of small ownership interests.

The temporary regulations provide that income will not be
recharacterized unless there is a disparity between the effective
rate at which the hybrid branch payment is taxed to the payee and a
hypothetical tax rate that measures the tax savings to the payor
from the deductible payment. This provision is similar to the rule
in �1.954-3(b), and adopts the same percentage tests as contained in
that provision. The regulations also provide a special high tax
exception applicable to the hybrid branch payment that is similar to
the one contained in section 954(b)(4). Comments are invited on
whether the rules of �1.954- 9T could cause inappropriate multiple
recharacterizations where the hybrid branch payments are made
through a series of related hybrid entities.

The temporary regulations provide that if these provisions affect an
entity that has elected under �301.7701-3(c) to be treated as an
entity disregarded as separate from its owner, such an entity may
elect to be classified as a corporation, provided it fulfills
certain requirements, notwithstanding the sixty-month limitation in
that section.

III. Related Provisions

These temporary regulations provide rules, contained in �1.954-1T(c)
(1)(i)(B), to prevent expenses, including related person interest
expense which would normally be allocable under section 954(b)(5) to
subpart F income of a CFC, from being allocated to a payment from
which the expense arises. The allocation limit applies: (i) to the
extent such payment is included in the subpart F income of the CFC;
(ii) if the expense arises from any payment by the CFC to a hybrid
partnership in which the CFC is a partner; and (iii) if the payment
reduces foreign tax and there is a significant disparity in tax
rates between the payor and payee jurisdictions.

These temporary regulations also address the application of the
related person exceptions to the foreign personal holding company
income rules in the context of partnership distributive shares and
transactions involving hybrid branches. Under section 954(c)(3),
foreign personal holding company income does not include certain
interest, dividends, rents and royalties received from related
corporations. These exceptions apply, in the case of interest and
dividends, when the related corporate payor is organized in the
country in which the CFC is organized and uses a substantial part of
its assets in a trade or business in that country and, in the case
of rents and royalties, when the rent or royalty payment is made for
the use or privilege of using property within the CFC's country of
incorporation.

The rules regarding the application of the related person exceptions
with respect to a CFC partner's distributive share of partnership
income are part of the broader set of rules addressing distributive
share issues in the context of subpart F contained in the proposed
regulations published elsewhere in this issue of the Federal
Register. Certain rules relating to the related person exception
with respect to a CFC partner's distributive share of partnership
income, and certain rules relating to the related person exception
with respect to hybrid branches, however, are included in these
temporary regulations because they address a fact pattern similar to
the one to which the hybrid branch payment rules apply. No inference
is intended as to the treatment under existing law of such
arrangements in relation to the related party exceptions.

Under these rules, if the partnership receives an item of income
that reduces the income tax of the payor, the related person
exceptions of section 954(c)(3) apply to exclude the income from the
foreign personal holding company income of the CFC partner only
where: the exception would have applied if the CFC earned the income
directly (testing relatedness and country of incorporation at the
CFC partner level); and either the partnership is organized and
operates in the CFC's country of incorporation, the partnership is
treated as fiscally transparent in the CFC's countries of
incorporation and operation, or there is no significant disparity
between the effective rate of tax imposed on the income and the rate
of tax that would be imposed on the income if earned directly by the
CFC partner.

The rules applying the related person exceptions with respect to
hybrid branches address transactions illustrated in the first
example of Notice 98-11 (1998-6 I.R.B. 13). These rules apply to
payments by a CFC to a hybrid branch of a related CFC. Under these
rules, the related person exceptions will apply to exclude the
payments from the foreign personal holding company income of the
recipient CFC only if the payment would have qualified for the
exception if the hybrid branch had been a separate CFC incorporated
in the jurisdiction in which the payment is subject to tax (other
than a withholding tax).

IV. Effective Date.

These regulations are effective March 23, 1998. For dates of
applicability see ��1.904-5T(o), 1.954-1T(c)(1)(i)(E), 1.954- 2T(a)
(5)(iii) and (6)(iii), 1.954-9T(d) and 301.7701-3T(f) of these
regulations.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedures Act
(5 U.S.C. chapter 5) does not apply to these regulations and,
because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Internal
Revenue Code, these temporary regulations will be submitted to the
Chief Counsel for Advocacy of the Small Business Administration for
comment on their impact on small business.

Drafting Information

The principal author of these regulations is Valerie Mark, of the
Office of the Associate Chief Counsel (International).

Other personnel from the IRS and Treasury Department also
participated in the development of these regulations.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping
requirements.

26 CFR Part 301 Employment taxes, Estate taxes, Excise taxes, Gift
taxes, Income taxes, Penalties, Reporting and recordkeeping
requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR parts
1 and 301 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for 26 CFR part 1 continues to
read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In �1.904-5, paragraph (o) is amended by adding a sentence
at the end to read as follows:

�1.904-5 Look-through rules as applied to controlled foreign
corporations and other entities.

* * * * *

(o) * * * Paragraph (k)(1) of this section does not apply on or
after March 23, 1998. For rules applicable on or after March 23,
1998, see �1.904-5T(k)(1).

Par. 3. �1.904-5T is added to read as follows:

�1.904-5T Look-through rules as applied to controlled foreign
corporations and other entities (temporary).

(a) through (j) [Reserved]. For further guidance, see �1.904-5(a)
through (j).

(k) Ordering rules--(1) In general. Income received or accrued by a
related person to which the look-through rules apply is
characterized before amounts included from, or paid or distributed
by, that person and received or accrued by a related person. For
purposes of determining the character of income received or accrued
by a person from a related person if the payor or another related
person also receives or accrues income from the recipient and the
look-through rules apply to the income in all cases, the rules of
paragraph (k)(2) of this section apply. Notwithstanding any other
provision of this section, the principles of �1.954-1T(c)(1)(i) will
apply to any expense subject to that subparagraph.

(k)(2) through (n) [Reserved]. For further guidance, see �1.904-5(k)
(2) through (n).

(o) Effective date. Section 1.904-5T(k)(1) applies on or after March
23, 1998. For rules prior to March 23, 1998, see �1.904-5(k)(1).

Par. 4. Section 1.954-0(b) is amended by revising the paragraph
heading and the entry for �1.954-0(b) in the list to read as
follows:

�1.954-0 Introduction.

* * * * *

(b) Outline of ��1.954-0, 1.954-1 and 1.954-2.

�1.954-0 Introduction.

* * * * *

(b) Outline of ��1.954-0, 1.954-1, and 1.954-2.

* * * * *

Par. 5. Section 1.954-1 is amended by adding a new paragraph (c)(1)
(iv) to read as follows:

�1.954-1 Foreign base company income.

* * * * *

(c) * * *

(1) * * *

(iv) Effective date. Paragraph (c)(1)(i) of this section does not
apply to all amounts paid or accrued on or after March 23, 1998,
except for amounts paid or accrued pursuant to arrangements entered
into before March 23, 1998, and not substantially modified
(including, for example, by expansion of the arrangement (whether by
exercise of an option or otherwise) such as by an increase in the
amount of or term of any borrowing, leasing or licensing
constituting the arrangement, changes in direct or indirect control
of any entity that is a party to the arrangement, or any similar
measure which materially increases the tax benefit of the
arrangement) on or after March 23, 1998.

For rules applicable on or after March 23, 1998, see �1.954- 1T(c)
(1)(i).

Par. 6. Section 1.954-1T is added to read as follows:

�1.954-1T Foreign base company income (temporary).

(a) through (c)(1)(i) [Reserved]. For further guidance, see
�1.954-1(a) through (c)(1).

(c)(1)(i) Deductions against gross foreign base company income--(A)
In general. [Reserved]. For further guidance, see �1.954-1(c)(1)(i).

(B) Special rule for deductible payments to certain non-fiscally
transparent entities. Notwithstanding any other provision of this
section, except as provided in paragraph (c)(1)(i)(C) of this
section, an expense (including a distributive share of any expense)
that would otherwise be allocable under section 954(b)(5) against
the subpart F income of a controlled foreign corporation shall not
be allocated against subpart F income of the controlled foreign
corporation resulting from the payment giving rise to the expense
if--

(1) Such expense arises from a payment between the controlled
foreign corporation and a partnership in which the controlled
foreign corporation is a partner and the partnership is not regarded
as fiscally transparent, as defined in �1.954- 9T(a)(7), by any
country in which the controlled foreign corporation does business or
has substantial assets; and

(2) The payment from which the expense arises would have met the
foreign tax reduction test of �1.954-9T(a)(3) and the tax disparity
test of �1.954-9T(a)(5)(iv) if those provisions had been applicable
to the payment.

(C) Limitations. Paragraph (c)(1)(i)(B) shall not apply to the
extent that the controlled foreign corporation partner has no income
against which to allocate the expense, other than its distributive
share of a payment described in paragraph (c)(1)(i)(B) of this
section. Similarly, to the extent an expense described in paragraph
(c)(1)(i)(B) of this section exceeds the controlled foreign
corporation partner's distributive share of the payment from which
the expense arises, such excess amount of the expense may reduce
subpart F income (other than such payment) to which it is properly
allocable or apportionable under section 954(b)(5).

(D) Example. The following example illustrates the application of
paragraph (c)(1)(i)(B) and (C) of this section:

Example. CFC, a controlled foreign corporation in Country A, is a 70
percent partner in partnership P, located in Country B. Country A's
tax laws do not classify P as a fiscally transparent entity. The
rate of tax in country B is 15 percent of the tax rate in country A.
P loans $100 to CFC at a market rate of interest. In year 1, CFC
pays P $10 of interest on the loan. The interest payment would have
caused the recharacterization rules of �1.954-9T to apply if the
payment were made between the entities described in �1.954-9T(a)(2).

CFC's distributive share of P's interest income is $7, which is
foreign personal holding company income to CFC under section 954(c).
Under paragraph (c)(1)(i)(B) of this section, $7 of the $10 interest
expense may not be allocated against any of CFC's subpart F income.
However, to the extent the remaining $3 of interest expense is
properly allocable to subpart F income of CFC other than its
distributive share of P's interest income, this expense may offset
such other subpart F income.

(E) Effective date. Paragraph (c)(1)(i)(B), (C) and (D) of this
section shall apply to all amounts paid or accrued on or after March
23, 1998, except for amounts paid or accrued pursuant to
arrangements entered into before March 23, 1998, and not
substantially modified (including, for example, by expansion of the
arrangement (whether by exercise of an option or otherwise) such as
by an increase in the amount of or term of any borrowing, leasing or
licensing constituting the arrangement, changes in direct or
indirect control of any entity that is a party to the arrangement,
or any similar measure which materially increases the tax benefit of
the arrangement) on or after March 23, 1998.

For rules applicable to amounts paid or accrued pursuant to
arrangements entered into before March 23, 1998, see �1.954-1.

(c)(1)(ii) through (f) [Reserved]. For further guidance, see
�1.954-1(c)(1)(ii) through (f).

Par. 7. Section 1.954-2T is added to read as follows:

�1.954-2T Foreign personal holding company income (temporary).

(a)(1) through (4) [Reserved]. For further guidance, see �1.954-2(a)
through (4).

(5) Special rules applicable to distributive share of partnership
income--(i) Application of related person exceptions where payment
reduces foreign tax of payor. If a partnership receives an item of
income that reduced the foreign income tax of the payor (determined
under the principles of �1.954-9T(a)(3)), to determine the extent to
which a controlled foreign corporation's distributive share of such
item of income is foreign personal holding company income, the
exceptions contained in section 954(c)(3) shall apply only if--

(A)(1) Any such exception would have applied to exclude the income
from foreign personal holding company income if the controlled
foreign corporation had earned the income directly (determined by
testing, with reference to such controlled foreign corporation,
whether an entity is a related person, within the meaning of section
954(d)(3), or is organized under the laws of, or uses property in,
the foreign country in which the controlled foreign corporation is
created or organized); and (2) The distributive share of such income
is not in respect of a payment made by the controlled foreign
corporation to the partnership; and

(B)(1) The partnership is created or organized, and uses a
substantial part of its assets in a trade or business in the country
under the laws of which the controlled foreign corporation is
created or organized (determined under the principles of �1.954-2(b)
(4));

(2) The partnership is regarded as fiscally transparent, as defined
in �1.954-9T(a)(7), by all countries under the laws of which the
controlled foreign corporation is created or organized or has
substantial assets; or

(3) The income is taxed in the year when earned at an effective rate
of tax (determined under the principles of �1.954- 1(d)(2)) that is
not less than 90 percent of, and not more than five percentage
points less than, the effective rate of tax that would have applied
to such income under the laws of the country in which the controlled
foreign corporation is created or organized if such income were
earned directly by the controlled foreign corporation partner from
local sources.

(ii) Certain other exceptions applicable to foreign personal holding
company income. [Reserved].

(iii) Effective date. Paragraph (a)(5)(i) of this section shall
apply to all amounts paid or accrued on or after March 23, 1998,
except for amounts paid or accrued pursuant to arrangements entered
into before March 23, 1998, and not substantially modified
(including, for example, by expansion of the arrangement (whether by
exercise of an option or otherwise) such as by an increase in the
amount of or term of any borrowing, leasing or licensing
constituting the arrangement, changes in direct or indirect control
of any entity that is a party to the arrangement, or any similar
measure which materially increases the tax benefit of the
arrangement) on or after March 23, 1998.

(6) Special rules applicable to exceptions from foreign personal
holding company income treatment in circumstances involving hybrid
branches--(i) In general. In the case of a payment between a
controlled foreign corporation (or its hybrid branch, as defined in
�1.954-9T(a)(6)) and the hybrid branch of a related controlled
foreign corporation, the exceptions contained in section 954(c)(3)
shall apply only if the payment would have qualified for the
exception if the payor were a separate controlled foreign
corporation created or organized in the jurisdiction where foreign
tax is reduced and the payee were a separate controlled foreign
corporation created or organized under the laws of the jurisdiction
in which the payment is subject to tax (other than a withholding
tax).

(ii) Exception where no tax reduction or tax disparity.

Paragraph (a)(6)(i) of this section shall not apply unless the
payment would have met the foreign tax reduction test of �1.954-
9T(a)(3) and the tax disparity test of �1.954-9T(a)(5)(iv) if those
provisions had been applicable to the payment.

(iii) Effective date. The rules of this section shall apply to all
amounts paid or accrued on or after January 16, 1998, except for
amounts paid or accrued pursuant to arrangements entered into before
January 16, 1998, and not substantially modified (including, for
example, by expansion of the arrangement (whether by exercise of an
option or otherwise) such as by an increase in the amount of or term
of any borrowing, leasing or licensing constituting the arrangement,
changes in direct or indirect control of any entity that is a party
to the arrangement, or any similar measure which materially
increases the tax benefit of the arrangement) on or after January
16, 1998.

(b) through (h) [Reserved]. For further guidance, see �1.954-2(b)
through (h).

Par. 8. Section 1.954-9T is added to read as follows:

�1.954-9T Hybrid branches (temporary).

(a) Subpart F income arising from certain payments involving hybrid
branches--(1) Payment causing foreign tax reduction gives rise to
additional subpart F income. The non-subpart F income of the
controlled foreign corporation will be recharacterized as subpart F
income, to the extent provided in paragraph (a)(5) of this section,
if--

(i) A hybrid branch payment, as defined in paragraph (a)(6) of this
section, is made between the entities described in paragraph (a)(2)
of this section;

(ii) The hybrid branch payment reduces foreign tax, as determined
under paragraph (a)(3) of this section; and

(iii) The hybrid branch payment is treated as falling within a
category of foreign personal holding company income under the rules
of paragraph (a)(4) of this section.

(2) Hybrid branch payment between certain entities--(i) In general.
Paragraph (a)(1) of this section shall apply to hybrid branch
payments between--

(A) A controlled foreign corporation and its hybrid branch;

(B) Hybrid branches of a controlled foreign corporation;

(C) A partnership in which a controlled foreign corporation is a
partner (either directly or through one or more branches or other
partnerships) and a hybrid branch of the partnership; or

(D) Hybrid branches of a partnership in which a controlled foreign
corporation is a partner (either directly or through one or more
branches or other partnerships).

(ii) Hybrid branch payment involving partnership--(A) Fiscally
transparent partnership. To the extent of the controlled foreign
corporation's proportionate share of a hybrid branch payment, the
rules of paragraphs (a)(3), (4) and (5) of this section shall be
applied by treating the hybrid branch payment between the
partnership and the hybrid branch as if it were made directly
between the controlled foreign corporation and the hybrid branch, or
as if the hybrid branches of the partnership were hybrid branches of
the controlled foreign corporation, if the hybrid branch payment is
made between--

(1) A fiscally transparent partnership in which a controlled foreign
corporation is a partner (either directly or through one or more
branches or other fiscally transparent partnerships) and the
partnership's hybrid branch; or

(2) Hybrid branches of a fiscally transparent partnership in which a
controlled foreign corporation is a partner (either directly or
through one or more branches or other fiscally transparent
partnerships).

(B) Non-fiscally transparent partnership. To the extent of the
controlled foreign corporation's proportionate share of a hybrid
branch payment, the rules of paragraphs (a)(3) and (4) and (a)(5)
(iv) of this section shall be applied to the non-fiscally
transparent partnership as if it were the controlled foreign
corporation, if the hybrid branch payment is made between--

(1) A non-fiscally transparent partnership in which a controlled
foreign corporation is a partner (either directly or through one or
more branches or other partnerships) and the partnership's hybrid
branch; or

(2) Hybrid branches of a non-fiscally transparent partnership in
which a controlled foreign corporation is a partner (either directly
or through one or more branches or other partnerships).

(C) Examples. The following examples illustrate the application of
this paragraph (a)(2)(ii).

Example 1. CFC, a controlled foreign corporation in Country A, is a
90 percent partner in partnership P, which is treated as fiscally
transparent under the laws of Country A. P has a hybrid branch, BR,
in Country B. P makes an interest payment of $100 to BR. Under
Country A law, CFC's 90 percent share of the payment reduces CFC's
Country A income tax. Under paragraph (a)(2)(ii)(A) of this section,
the recharacterization rules of this section are applied by treating
the payment as if made by CFC to BR. Ninety dollars of CFC's non-
subpart F income, to the extent available, and subject to the
earnings and profits and tax rate limitations of �1.954-9T(a)(5), is
recharacterized as subpart F income.

Example 2. CFC, a controlled foreign corporation in Country A, is a
90 percent partner in partnership P, which is treated as fiscally
transparent under the laws of Country A. P has two branches in
Country B, BR1 and BR2. BR1 is treated as fiscally transparent under
the laws of Country A. BR2 is a hybrid branch.

BR1 makes an interest payment of $100 to BR2. Under paragraph (a)(2)
(ii)(A) of this section, the payment by BR1, the fiscally
transparent branch, is treated as a payment by P, and the deemed
payment by P, a fiscally transparent partnership, is treated as made
by CFC. Under Country A law, CFC's 90 percent share of BR1's payment
reduces CFC's Country A income tax. Ninety dollars of CFC's non-
subpart F income, to the extent available, and subject to the
earnings and profits and tax rate limitations of �1.954-9T(a)(5), is
recharacterized as subpart F income.

(3) Application when payment reduces foreign tax. For purposes of
paragraph (a)(1) of this section, a hybrid branch payment reduces
foreign tax when the foreign tax imposed on the income of the payor
or any owner of the payor is less than the foreign tax that would
have been imposed on such income had the hybrid branch payment not
been made, or the hybrid branch payment creates or increases a loss
or deficit or other tax attribute which may be carried back or
forward to reduce the foreign income tax of the payor or any owner
in another year (determined by taking into account any refund of
such tax made to the payor, payee or any other person).

(4) Hybrid branch payment that is included within a category of
foreign personal holding company income--(i) In general. For
purposes of paragraph (a)(1) of this section, whether the hybrid
branch payment is treated as income included within a category of
foreign personal holding company income is determined by treating a
hybrid branch that is either the payor or recipient of the hybrid
branch payment as a separate wholly-owned subsidiary corporation of
the controlled foreign corporation that is incorporated in the
jurisdiction under the laws of which such hybrid branch is created,
organized for foreign law purposes, or has substantial assets. Thus,
the hybrid branch payment will be treated as included within a
category of foreign personal holding company income if, taking into
account any specific exceptions for that category, the payment would
be included within a category of foreign personal holding company
income if the branch or branches were treated as separately
incorporated for U.S. tax purposes.

(ii) Extent to which controlled foreign corporation and hybrid
branches treated as separate entities. For purposes other than the
determination under paragraph (a)(4)(i) of this section, a
controlled foreign corporation and its hybrid branch, a partnership
and its hybrid branch, or hybrid branches shall not be treated as
separate entities. Thus, for example, if a controlled foreign
corporation, including all of its hybrid branches, has an overall
deficit in earnings and profits to which section 952(c) applies, the
limitation of such section on the amount includible in the subpart F
income of such corporation will apply. Similarly, for purposes of
applying the de minimis and full inclusion rules of section 954(b)
(3), a controlled foreign corporation and its hybrid branch, or
hybrid branches shall not be treated as separate corporations.
Further, a hybrid branch payment that would reduce foreign personal
holding company income under section 954(b)(5) if made between two
separate entities will not create an expense if made between a
controlled foreign corporation and its hybrid branch, a partnership
and its hybrid branch, or hybrid branches.

(5) Recharacterization of income attributable to current earnings
and profits as subpart F income--(i) General rule. Non-subpart F
income of a controlled foreign corporation in an amount equal to the
excess of earnings and profits of the controlled foreign corporation
for the taxable year over subpart F income, as defined in section
952(a), will be recharacterized as subpart F income under paragraph
(a)(1) of this section only to the extent provided under paragraphs
(a)(5)(ii) through (vi) of this section.

(ii) Subpart F income. For purposes of determining the excess of
current earnings and profits over subpart F income under paragraph
(a)(1) of this section, the amount of subpart F income is determined
before the application of the rules of this section but after the
application of the rules of sections 952(c) and 954(b). Further,
such amount is determined by treating the controlled foreign
corporation and all of its hybrid branches as a single corporation.

(iii) Recharacterization limited to gross amount of hybrid branch
payment--(A) In general. The amount recharacterized as subpart F
income under paragraph (a)(1) of this section is limited to the
amount of the hybrid branch payment.

(B) Exception for duplicative payments. [Reserved].

(iv) Tax disparity rule--(A) In general. Paragraph (a)(1) of this
section will apply only if the hybrid branch payment falls within
the tax disparity rule. The hybrid branch payment falls within the
tax disparity rule if it is taxed in the year when earned at an
effective rate of tax that is less than 90 percent of, and at least
5 percentage points less than, the hypothetical effective rate of
tax imposed on the hybrid branch payment, as determined under
paragraph (a)(5)(iv)(B) of this section.

(B) Hypothetical effective rate of tax--(1) In general. The
hypothetical effective rate of tax imposed on the hybrid branch
payment is--

(i) For the taxable year of the payor in which the hybrid branch
payment is made, the amount of income taxes that would have been
paid or accrued by the payor if the hybrid branch payment had not
been made, less the amount of income taxes paid or accrued by the
payor; divided by

(ii) The amount of the hybrid branch payment.

(2) Hypothetical effective rate of tax when hybrid branch payment
causes or increases loss or deficit. If the hybrid branch payment
causes or increases a loss or deficit of the payor for foreign tax
purposes, and such loss or deficit can be carried forward or back,
the hypothetical effective rate of tax imposed on the hybrid branch
payment is the effective rate of tax that would be imposed on the
taxable income of the payor for the year in which the foreign law
payment is made if the payor's taxable income were equal to the
amount of the hybrid branch payment.

(C) Examples. The application of this paragraph (a)(5)(iv) is
illustrated by the following examples.

Example 1. In 1998, CFC organized in Country A had net income of $60
from manufacturing for Country A tax purposes. It also had a branch
(BR) in Country B. BR is a hybrid entity under paragraph (a)(1) of
this section. CFC made a payment of $40 to BR, which was a hybrid
branch payment under paragraph (a)(6) of this section, and was
treated by CFC as a deductible payment for Country A tax purposes.
CFC paid $30 of Country A taxes in 1998.

It would have paid $50 of Country A taxes without the deductible
payment. Country A did not impose any withholding tax on the $40
payment to BR. Country B also did not impose a tax on the $40
received by BR. Therefore, the effective rate of tax on that payment
is 0%. Furthermore, the hypothetical effective rate of tax on the
$40 hybrid branch payment is 50% ($50-$30/$40). The effective rate
of tax (0%) is less than 90% of, and more than 5 percentage points
less than, this hypothetical rate of tax of 50%. As a result, the
$40 hybrid branch payment falls within the tax disparity rule of
this paragraph (a)(5)(iv).

Example 2. Assume the same facts as in Example 1, except that CFC
has a loss of $100 for the year for Country A tax purposes. Under
Country A law, CFC can carry the loss forward for use in subsequent
years. CFC paid no Country A taxes in 1998. The rate of tax in
Country A is graduated from 20% to 50%.

If the $40 hybrid branch payment were the only item of taxable
income of CFC, Country A would have imposed tax at an effective rate
of 30%. The effective rate of tax (0%) is less than 90 percent of,
and more than 5 percentage points less than, the hypothetical
effective rate of tax (30%) imposed on the hybrid branch payment. As
a result, the $40 hybrid branch payment falls within the tax
disparity rule of this paragraph (a)(5)(iv).

Example 3. Assume the same facts as in Example 1, except that
Country B imposes tax on the $40 hybrid payment to BR at an
effective rate of 50%. The effective rate of 50% is equal to the
hypothetical effective rate of tax. As a result, the hybrid branch
payment does not fall within the tax disparity rule of this
paragraph (a)(5)(iv) and, thus, the recharacterization rules of
paragraph (a)(1) of this section do not apply. See also the special
high tax exception of paragraph (a)(5)(v) of this section.

(v) Special high tax exception--(A) In general. Paragraph (a)(1) of
this section shall not apply if the non-subpart F income
recharacterized as subpart F income under this section was subject
to foreign income taxes imposed by a foreign country or countries at
an effective rate that is greater than 90 percent of the maximum
rate of tax specified in section 11 for the taxable year of the
controlled foreign corporation.

(B) Effective rate of tax. The effective rate of tax imposed on the
net amount of the hybrid branch payment is determined under the
principles of �1.954-1(d)(2) and (3). See paragraph (c) of this
section for the application of section 960 to amounts
recharacterized as subpart F income under this section.

(vi) No carryback or carryforward of amounts in excess of current
year earnings and profits limitation. To the extent that some or all
of the amount required to be recharacterized under this section is
not recharacterized as subpart F income because the hybrid branch
payment exceeds the amount that can be recharacterized, as
determined under paragraph (a)(5)(i) of this section, this excess
shall not be carried back or forward to another year.

(6) Definitions. For purposes of this section-- Entity means any
person that is treated by the United States or any jurisdiction as
other than an individual.

Hybrid branch means an entity that--

(i) Has a single owner (including ownership through branches) that
is either a controlled foreign corporation or a partnership in which
a controlled foreign corporation is a partner (either directly or
indirectly through one or more branches or partnerships);

(ii) Is treated as fiscally transparent by the United States; and

(iii) Is treated as non-fiscally transparent by the country in which
the payor entity, any owner of a fiscally-transparent payor entity,
the controlled foreign corporation, or any intermediary partnership
is created, organized or has substantial assets.

Hybrid branch payment means the gross amount of any payment
(including any accrual) which, under the tax laws of any foreign
jurisdiction to which the payor is subject, is regarded as a payment
between two separate entities but which, under U.S. income tax
principles, is not income to the recipient because it is between two
parts of a single entity.

(7) Fiscally transparent and non-fiscally transparent. For purposes
of this section an entity shall be treated as fiscally transparent
with respect to an interest holder of the entity, if such interest
holder is required, under the laws of any jurisdiction to which it
is subject, to take into account separately, on a current basis,
such interest holder's share of all items which, if separately taken
into account by such interest holder, would result in an income tax
liability for the interest holder in such jurisdiction different
from that which would result if the interest holder did not take the
share of such items into account separately. A non-fiscally
transparent entity is an entity that is not fiscally transparent
under this paragraph (a)(7).

(b) Election to change classification--(1) In general. If a hybrid
branch subject to the provisions of paragraph (a) of this section is
an entity that has made an election under �301.7701- 3(c)(1) of this
chapter to be disregarded as an entity separate from its owner, such
entity may elect to change its classification to that of an
association taxable as a corporation, under the procedures described
in �301.7701-3(c) of this chapter, without regard to the limitation
of �301.7701- 3T(c)(1)(iv) of this chapter, but only if such
election is made on or before the last day of the first taxable year
beginning on or after January 1, 1998. An election made pursuant to
this paragraph (b)(1) is effective as of the first day of such
taxable year. The 75 day limitation on retroactivity in �301.7701-
3(c)(1)(iii) of this chapter does not apply.

(2) Limitation. An entity can elect to change its classification
under the provisions of this paragraph only one time.

(c) Application of section 960. For purposes of determining the
amount of taxes deemed paid under section 960, the amount of non-
subpart F income recharacterized as subpart F income under this
section shall be treated as attributable to income in separate
categories, as defined in �1.904-5(a)(1), in proportion to the ratio
of non-subpart F income in each such category to the total amount of
non-subpart F income of the controlled foreign corporation for the
taxable year.

(d) Effective dates--(1) Hybrid branches of controlled foreign
corporations. With respect to hybrid branch payments described in
paragraph (a)(2)(i)(A) and (B) of this section, the rules of this
section shall apply to all amounts paid or accrued on or after
January 16, 1998, except for amounts paid or accrued pursuant to
arrangements entered into before January 16, 1998, and not
substantially modified (including, for example, by expansion of the
arrangement (whether by exercise of an option or otherwise) such as
by an increase in the amount of or term of any borrowing, leasing or
licensing constituting the arrangement, changes in direct or
indirect control of any entity that is a party to the arrangement,
or any similar measure which materially increases the tax benefit of
the arrangement) on or after January 16, 1998.

(2) Hybrid branches of partnerships in which controlled foreign
corporations are partners. With respect to hybrid branch payments
described in paragraph (a)(2)(i)(C) and (D) of this section, the
rules of this section shall apply to all amounts paid or accrued on
or after March 23, 1998, except for amounts paid or accrued pursuant
to arrangements entered into before March 23, 1998, and not
substantially modified (including, for example, by expansion of the
arrangement (whether by exercise of an option or otherwise) such as
by an increase in the amount of or term of any borrowing, leasing or
licensing constituting the arrangement, changes in direct or
indirect control of any entity that is a party to the arrangement,
or any similar measure which materially increases the tax benefit of
the arrangement) on or after March 23, 1998.

PART 301--PROCEDURE AND ADMINISTRATION

Par. 9. The authority citation for 26 CFR part 301 continue to read
in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 10. In �301.7701-3, paragraph (f)(1) is amended by adding a
sentence at the end to read as follows:

�301.7701-3. Classification of certain business entities.

* * * * *

(f)(1) * * * Paragraphs (a), (c)(1)(iv) and (f) of this section do
not apply on or after March 23, 1998. For rules applicable on or
after March 23, 1998, see �301.7701-3T(a), (c)(1)(iv) and (f).

Par. 11. Section 301.7701-3T is added to read as follows:

�301.7701-3T Classification of certain business entities
(temporary).

(a) In general. A business entity that is not classified as
corporation under �301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8)
(an eligible entity) can elect its classification for federal tax
purposes as provided in this section. An eligible entity with at
least two members can elect to be classified as either an
association (and thus a corporation under �301.7701-2(b)(2)) or a
partnership, and an eligible entity with a single owner can elect to
be classified as an association or to be disregarded as an entity
separate from its owner. Paragraph (b) of this section provides a
default classification for an eligible entity that does not make an
election. Thus, elections are necessary only when an eligible entity
chooses to be classified initially as other than the default
classification or when an eligible entity chooses to change its
classification. An entity whose classification is determined under
the default classification retains that classification (regardless
of any changes in the members' liability that occurs at any time
during the time that the entity's classification is relevant as
defined in paragraph (d) of this section) until the entity makes an
election to change that classification under paragraph (c)(1) of
this section.

Paragraph (c) of this section provides rules for making express
elections. Paragraph (d) provides special rules for foreign eligible
entities. Paragraph (e) of this section provides special rules for
classifying entities resulting from partnership terminations and
divisions under section 708(b). Paragraph (f) of this section sets
forth the effective date of this section and a special rule relating
to prior periods. An entity that has elected to be disregarded as an
entity separate from its owner may nevertheless be treated as a
corporation for the limited purposes of �1.954-9T(a)(4)(i) of this
chapter.

(b) through (c)(1)(iii) [Reserved]. For further guidance, see
�301.7701-3(b) through (c)(1)(iii).

(c)(1)(iv) Limitation. If an eligible entity makes an election under
paragraph (c)(1)(i) of this section to change its classification
(other than an election made by an existing entity to change its
classification as of the effective date of this section), the entity
cannot change its classification by election again during the sixty
months succeeding the effective date of the election. However, the
Commissioner may permit the entity to change its classification by
election within the sixty months if more than fifty percent of the
ownership interests in the entity as of the effective date of the
subsequent election are owned by person that did not own any
interests in the entity on the filing date or on the effective date
of the entity's prior election.

See �1.954-9T(b) of this chapter, for circumstances under which
certain eligible entities may make an election to change their
classification within the sixty-month period.

(c)(1)(v) through (e) [Reserved]. For further guidance, see
�301.7701-3(c)(1)(v) through (e)..(f) Effective date. Section
301.7701-3T(a) and (c)(1)(iv) applies on or after March 23, 1998.
For rules prior to March 23, 1998, see �301.7701-3(a) and (c)(1)
(iv).

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved:
Donald C. Lubick
Assistant Secretary of the Treasury

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