Recent IRS Guidance on Branch Profits Tax Treaty Benefits for Foreign Reverse Hybrid Entities

The IRS recently issued a Chief Counsel Advice Memorandum (AM 2025-002) (the CCA) that provides helpful guidance regarding the application of the branch profits tax (BPT) in connection with reverse foreign hybrid (RFH) entities and U.S. income tax treaties with foreign countries.[1] The CCA’s conclusion that treaty benefits are available for the BPT based on the qualifications and residence of an RFH’s owners is significant for investment funds that use them in a “Bring Your Own Treaty” fund structure.

Under Section 884,[2] the BPT is imposed on income deemed to be repatriated as a “dividend equivalent amount” (DEA) by a non-U.S. corporation engaged in a U.S. trade or business.[3] The BPT is intended to approximate the U.S. federal income tax withholding that would apply to a U.S. corporation’s payment of a dividend to a non-U.S. shareholder. While the BPT ordinarily is imposed at a 30% rate, an income tax treaty can reduce or eliminate the BPT attributable to a non-U.S. corporation that is a qualified resident of the applicable treaty country.[4]

An RFH is an entity that is not fiscally transparent for U.S. federal income tax purposes (i.e., treated as a corporation) and fiscally transparent for applicable non-U.S. income tax purposes (i.e., a pass-through).  

The CCA addresses how U.S. income tax treaties apply to the BPT with respect to income realized through an RFH entity where the entity was treated as a corporation for U.S. federal income tax purposes but a pass-through in the jurisdiction of residence of its foreign owners, some of whom qualified for benefits under an applicable income tax treaty. As discussed above, the BPT generally is imposed at a 30% rate on the DEA. However, an applicable income tax treaty can reduce or eliminate the BPT if the taxpayer is a “resident” entitled to treaty benefits and qualifies under the treaty’s “limitation on benefits” (LOB) requirements. In addition, such a treaty can also apply a “fiscally transparent” rule (FTE Rule) that treats the business profits derived through a fiscally transparent entity as being derived by the owners of that entity for treaty purposes.[5]

While Section 1.894-1(d) allows for a foreign person to derive treaty benefits through a fiscally transparent entity (the Section 894 Regulations), including an RFH, these regulations do not apply to income other than “fixed, determinable, annual, or periodical” income; that is, income that generally is passive under the Internal Revenue Code. Thus, the Section 894 Regulations do not apply to ECI realized by an RFH.

It has historically been unclear whether an RFH can qualify for reduction of the BPT on income not falling within the Section 894 Regulations because of the lack of guidance regarding whether:

• a treaty’s FTE Rule could preempt the “non-U.S. corporation” language of Section 884 in imposing the BPT and instead look to whether the underlying owners were treaty residents
• the treaty’s “resident” requirements should apply to the entity itself or its owners and
• a treaty’s LOB provisions should apply to the entity itself or instead to its owners.

This uncertainty impacted whether to use RFHs in which treaty-resident investors could potentially benefit from a reduction in the BPT.

In the CCA, two out of four owners of an RFH entity were qualified residents of a country with a treaty (that is, they met the treaty’s LOB provisions) which reduced the BPT from the 30% statutory rate. Such owners did not have a permanent establishment in the United States. The entity was treated as a corporation for U.S. federal income tax purposes but was fiscally transparent in its country of organization and in the countries of residence of its owners. The entity’s income was effectively connected with a U.S. trade or business and, under the treaty, treated as business profits attributable to a permanent establishment in the United States. The entity complied with all U.S. tax reporting requirements and tax obligations, as well as applicable documentation requirements for claiming a reduced BPT rate on its DEA under the treaty. The relevant treaty also included an FTE Rule.

The CCA concluded that, although the entity was treated as a corporation for U.S. federal income tax purpose and therefore was the taxpayer for corporate income tax and BPT purposes, any treaty reductions to the BPT rate could apply on an owner-by-owner basis. The CCA found that while the FTE Rule does not override the mechanics of Section 884 (and therefore the calculation of the DEA stays the same), the treaty may modify the applicable tax rate with respect to the portions of the entity’s DEA that were allocable to owners qualifying for treaty benefits. The treaty-based rate reductions would apply proportionally with respect to each owner, provided that at year-end:

• the owner is a resident of the treaty country
• the owner is taxed on its share of income under the laws of its country of residence; and

• the owner meets the LOB requirements under the treaty (and the treaty includes the FTE Rule).

Although the CCA is not binding legal authority, the CCA’s conclusion provides helpful clarification with respect to the application of a treaty to the BPT in structuring investment funds with an RFH entity. For example, where a credit fund that is an RFH entity is relying on the treaties of its investors to establish “independent agency” to avoid a U.S. permanent establishment and reduce U.S. federal income tax withholding to zero (commonly referred to as a “Bring Your Own Treaty” structure),[6] it appears that the IRS would not impose the BPT on the fund.

The authors appreciate the comments provided by David Makso.

[1] A CCA, like an IRS private letter ruling, cannot be used or cited as precedent, but can provide the views of the IRS National Office.  Section 6110(k).

[2] All “Section” references are to the U.S. Internal Revenue Code of 1986, as amended, or the Treasury Regulations promulgated thereunder.

[3] Section 884.

[4] For example, the U.S.-Canada Income Treaty reduces the BPT to 5% of a qualified Canadian corporate resident’s DEA.

[5] See, e.g., the U.S.-Canada Income Tax Treaty.

[6] See Taisei v. Commissioner, 104 T.C. 535 (1995), acq., 1996-1 I.R.B. 5.