The IRS Chief Counsel ruled that reverse foreign hybrids may qualify for reduced branch profits tax on dividend equivalent amounts attributable to treaty-eligible owners.

The US Internal Revenue Service (IRS) Chief Counsel has determined that “reverse foreign hybrids” may qualify for reduced branch profits tax (BPT) in some cases. Specifically, in memorandum (AM2025-002), it was concluded that a reverse foreign hybrid could receive reduced BPT rates on the portion of dividend equivalent amounts (DEAs) attributable to owners who are residents of a treaty country and satisfy applicable treaty conditions.

A reverse foreign hybrid is a foreign entity treated as a corporation for U.S. tax purposes but considered fiscally transparent in its home country.

The branch profits tax (BPT) applies to the after-tax earnings of a foreign corporation’s U.S. branch that are not reinvested, effectively treating them like dividends paid by a U.S. subsidiary to its foreign parent.

Overview 

There is little guidance directly addressing the interaction of U.S. income tax treaties and domestic law as applicable to a foreign entity that is taxable as a corporation for U.S. tax purposes but is fiscally transparent under the law of an owner’s jurisdiction (a “reverse foreign hybrid”) that earns business profits. Certain points may be helpful to the principal issue addressed by this memorandum.

  • Even in the case of a reverse foreign hybrid organised under the laws of a treaty partner, the entity is not a resident for treaty purposes if it is fiscally transparent under the laws of the treaty partner, and thus cannot meet the “liable to tax” requirement for residence.
  • The FTE provision of a treaty may allow treaty benefits with respect to income or profits earned by a reverse foreign hybrid to the extent that owners qualify for benefits under a treaty.
  • It follows that the LOB provision of income tax treaties is applied on an owner-by-owner basis to determine if an owner that is a resident of a treaty partner is treaty-qualified.
  • If a reverse foreign hybrid entity earns business profits that are not attributable to a U.S. permanent establishment of either the entity or (to the extent of the owner’s interest) a treaty-qualified owner of the entity, such business profits may qualify for exemption under the Business Profits article to the extent corresponding to the interest held by that treaty-qualified owner.
  • The FTE provision does not change the identity of the taxpayer under source State tax law and does not disturb source State taxation of a reverse foreign hybrid that otherwise applies. Thus, if the business profits are attributable to a U.S. permanent establishment of either the entity or (to the extent of the owner’s interest) an owner of the entity, such business profits will be taxable in the United States in accordance with the tax treaty at the corporate rate. The fact that the profits may be considered derived by a treaty-qualified owner who does not have a separate U.S. permanent establishment does not change the result.
  • A reverse foreign hybrid that earns business profits is required to file a U.S. corporate income tax return and report as gross income any non-exempt income and determine and satisfy its U.S. Federal income tax liability thereon.
  • In addition, the reverse foreign hybrid is required to report and satisfy its liability under the section 884 branch profits tax provisions, as adjusted for applicable treaty reductions, if any, on its DEA in respect of income attributable to its permanent establishment. For this purpose, and as discussed below, the entity-level characterisation of income as business profits of a company attributable to a U.S. permanent establishment applies in determining the branch profits liability of the reverse foreign hybrid corresponding to the interest of a treaty-qualified owner, even if that owner is not itself a company or does not have a separate U.S. permanent establishment.
  • The remainder of this memorandum addresses in greater detail the potential applicability of a reduction to a reverse foreign hybrid’s branch profits tax liability under the BPT provision of an income tax treaty, taking into account the FTE provision, including the residence and LOB requirements for an owner to be treaty-qualified.