Sean Foley

Recently, the IRS Large and Midsize Business Division (LMSB) issued a new industry directive (LMSB-04-0407-035) focusing increased audit efforts on certain international hybrid instrument transactions. International hybrid instrument transactions are cross-border financing arrangements in which the taxpayer takes different positions in its treatment of the transaction as debt or equity for US and foreign tax purposes.

The new directive is part of the IRS initiative establishing the industry issue focus (IIF) program. The IIF program identifies and prioritises significant industry issues by dividing them into three tiers: Tier I, Tier II, and Tier III. In addition, the issues are separated into potentially abusive issues and compliance issues.

International hybrid instrument transactions have been assigned a Tier I status. Tier I issues are those that have high strategic importance, a significant impact on one or more industries, high dollar risk, substantial compliance risk, or high visibility. They are also those where the IRS considers the law or the IRS position on these issues to be well established.

The new directive:

1. Provides the field with guidance on whether certain cross-border financing transactions between related parties should be treated as debt or equity for US tax purposes;
2. Establishes that international hybrid instrument transactions are a mandatory examination issue requiring approval by the International Hybrid Instrument Transaction Issue Management Team; and
3. Helps IRS agents to identify these transactions through tax returns and other documentation.

The directive identifies two types of international hybrid transactions: (a) "Debt in US Transactions" (when a taxpayer treats a cross-border financing arrangement as debt for US purposes and equity for foreign tax purposes); and (b) "Equity in US Transactions" (essentially the reverse of the Debt in US Transactions).

The directive says that taxpayers can achieve the following benefits with Debt in US Transactions: (i) interest expense deduction in the US; (ii) reduced withholding rates on interest payment under an applicable income tax treaty (circumventing the "reverse hybrid regulations" under section 894(c)); (iii) non-recognition of interest income in the foreign jurisdiction; and (iv) foreign tax credits in the foreign jurisdiction.

The directive notes that Debt in US Transactions generally involve the use of hybrid entities and various stock purchase agreements. There are two types of transactions:

1. transactions treated by the taxpayer as repurchase agreements (the directive states that examiners should request copies of the forward purchase agreement and the guarantee agreement); and
2. transactions involving subscription agreements (the directive states that examiners should request copies of the agreement or the share purchase agreement).

With respect to Equity in US Transactions, the directive points to a generic legal advice memorandum released by the office of chief counsel on September 26 2006. The memorandum concluded that a promissory note and a forward purchase agreement should be considered together with the result that they are treated as a single instrument and considered equity for US tax purposes. Other Equity in US Transactions include fact patterns where the ownership of a related off-shore entity is considered equity for US tax purposes and debt for foreign tax purposes.

Another typical Equity in US Transactions described in the directive involve a US corporation that wholly owns both a disregarded entity (DE) and a controlled foreign corporation (CFC). The DE borrows funds from an unrelated party, and loans the funds to the CFC in exchange for a promissory note. The promissory note is treated as debt for foreign tax purposes. For US tax purposes the promissory note and a forward purchase agreement between the US corporation and the CFC are treated as one instrument and considered equity rather than debt.

What this means for taxpayers

Taxpayers should be aware that, based on the new directive, the IRS is required to examine and may well challenge international hybrid instrument transactions on audit.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

Sean Foley (sffoley@kpmg.com), Washington DC