A group could set up an entity that is treated as fiscally transparent for U.S. federal tax purposes but is treated as an entity in the country in which it is resident or subject to tax. Similarly, an instrument may be treated as debt in one country but not in another, and this could (in the absence of further legislation) result in deductible interest expense in the payer’s jurisdiction but treatment as an exempt dividend in the recipient’s country.

The Tax Cuts and Jobs Act therefore proposes to prohibit a tax deduction for any disqualified related party amount paid or accrued under a hybrid transaction or paid by (or to) a hybrid entity.

A disqualified related party amount is any interest or royalty paid or accrued to a related party if the amount is not included in the income of the related party under the tax law of the country where the related party is tax resident subject to tax; or if the related party is allowed a deduction for the amount under the tax law of that country. A disqualified related party amount does not include any payment that is included in the gross income of a U.S. shareholder under section 951(a) of the tax code.

A hybrid transaction is defined as any transaction, series of transactions, agreement, or instrument in relation to which one or more payments are treated as interest or royalties for US tax purposes but are not so treated by the tax law of the foreign country where the recipient of the payment is tax resident or subject to tax.

A hybrid entity is defined as any entity which is treated as fiscally transparent for US tax purposes but not so treated under the tax law of the foreign country where the entity is resident for tax purposes or subject to tax; or an entity that is treated as fiscally transparent for purposes of the foreign tax law but not so treated for US tax purposes.