When the Anti-Conduit Rules Became Synonymous with Anti-Hybrid Rules: A Discussion of Proposed Reg. §1.881-3

Abstract

The following Figure 1 provides a basic example of a hybrid mismatch using a financial instrument that is classified as debt in Country B and equity in Country A. Because Country A treats the instrument as equity and has what is referred to as a "participation exemption system," the distribution is classified as a dividend, and it is not included in the tax base of the Country A payee. Because Country B treats the instrument as debt, however, the distribution is classified as interest expense providing a deduction to the tax base of the Country B payor. A. Enactment of Code Sec. 7701 Code Sec. 7701(l) was enacted in 1993 to initially address concerns about conduit entities avoiding U.S. withholding taxes through treaty shopping and certain financing transactions.5 The legislative history that accompanied the enactment of Code Sec. 7701(l) cited Aiken Industries, Inc.6 and stated that Congress believed the Treasury and the IRS needed more regulatory authority to combat withholding tax avoidance through multiple-party financing arrangements, including debt and equity financed arrangements.7 Congress authorized the Treasury "to promulgate regulations that set forth rules for recharacterizing any multiple-party financing transaction as a transaction directly among any two or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by the Internal Revenue Code. "8 The purpose of Code Sec. 7701(l) therefore appears limited to combating conduit entities that facilitated the avoidance of tax under Code Secs. 881 and 1441.9 However, the plain language of Code Sec. 7701(l) has been interpreted by the Treasury to be broader, and has been cited as authority for regulations addressing "fast-pay stock" transactions, as well as rules addressing inversions and "de-control" transactions.10 B. Proposed Regulations In 1994, the Treasury issued proposed regulations under Code Sec. 881 targeting financing arrangements undertaken to avoid tax (the "1994 Proposed 881 Regulations").11 The 1994 Proposed 881 Regulations generally targeted financing arrangements, whereby (1) a financing entity advances money or other property to an intermediate entity; (2) that intermediate entity advances money or other property to a financed entity; and (3) withholding taxes are reduced because of the participation of the intermediate entity. An advance of money or other property in exchange for stock will be considered a financing transaction only if the issuer or holder of the stock has rights, or there are arrangements in place, that are intended to ensure that payments on the instrument will be made as contemplated. [...]an exchange for common stock or ordinary perpetual preferred stock will not be included.