IRS Issues Industry Director Directive on International Hybrid Instrument Transactions

Tax Controversy Alert

Earlier this year, LMSB announced its Industry Focus (“IIF”) program as part of its effort to coordinate its approach to developing strategic issues for enforcement and potential litigation. See Miller & Chevalier Tax ax Alert of March 13, 2007. Under this program, LMSB prioritizes IIF issues into “tiers”, with “Tier I” issues being those issues that LMSB has determined to have high strategic importance, a significant impact on one or more industries, high dollar risk, substantial compliance risk, or high visibility. With respect to these Tier I issues, LMSB has issued a series of Industry Issue Directives (“IIDs”) to provide further direction to the field to ensure that the issue is identified, developed and resolved in a consistent manner. International hybrid instrument transactions have been identified as a Tier I issue.

On June 15, 2007, LMSB issued an IID regarding the treatment of international hybrid instrument transactions. As an initial matter, the IID notes that these transactions are mandatory examination issues and that any resolution of these issues requires approval of the Issue Management Team (“IMT”). See Miller & Chevalier Tax Alert of July 6, 2006.

The IID describes international hybrid instrument transactions as “cross-border financing arrangements in which the taxpayer takes different positions in its treatment of the transactions as debt or equity for U.S. and foreign tax purposes.” Thus, the IID describes the core issue relating to these transactions as “whether these cross-border financing transactions entered into between related parties should be treated as debt or equity under U.S. federal law, including Section 385.”

Debt in U.S. Transactions

The IID first discusses so-called “Debt in U.S. Transactions,” in which a cross-border financing arrangement is treated as debt for U.S. tax purposes and equity for foreign purposes. The IID notes that such transactions can achieve a number of benefits, including (i) the creation of interest expense deductions in the U.S., (ii) reduced treaty withholding tax rates on interest payments, (iii) nonrecognition of interest income in the foreign jurisdiction, and (iv) the creation of foreign tax credits in the foreign jurisdiction. Thus, these transactions generate interest deductions in the U.S. without incurring U.S. or foreign tax on the corresponding interest income. The IID describes the form of these transactions, noting that they typically involve the use of hybrid entities and various stock purchase agreements (including repurchase agreements).

Equity in U.S. Transactions

The IID also discusses so-called “Equity in U.S. Transactions,” noting that Generic Legal Advice Memorandum (“GLAM”) AM 2006-001 (Sept. 26, 2006) discusses a typical transaction. In the GLAM, a U.S. corporation wholly owns both a disregarded entity and a CFC. The disregarded entity borrows funds from an unrelated party and loans the funds to the CFC in exchange for a promissory note, which is treated as debt for foreign tax purposes. The GLAM concluded that the promissory note and a related forward purchase agreement between the U.S. corporation and the CFC should be treated as one instrument and, therefore, considered equity rather than debt for U.S. tax purposes.

Field Review of International Hybrid Instrument Transactions

The IID directs the field to review and challenge all arguments by taxpayers who claim that these transactions are debt or equity for U.S. tax purposes. In this regard, the IID notes that the analysis is very fact specific and requires a careful examination of the documents executed in the transaction. The IID notes that the assistance of an International Examiner and a Financial Products Specialist should be requested. In this regard, the IID directs that IDRs with respect to hybrid transactions be prepared by an International Examiner and Financial Products Specialists and that pro-forma IDRs will be developed and shared with the field as soon as they become available.

With respect to so-called “Equity in U.S. Transactions,” the IID directs the field to consult with local counsel and the IMT to determine if a transaction is substantially similar to the transaction described in the GLAM. If so, the IID directs the field to follow the conclusions in the GLAM. Otherwise, the field is directed to challenge the purported results of the transaction.

The IID also directs the field to consult with the IMT to determine whether other cross-border transactions involving Section 385 fall under the IID.


Although the IID is not an official pronouncement of the IRS position regarding international hybrid instrument transactions, it does provide useful guidance as to the level and amount of scrutiny that these transactions will receive at the examination level. On a substantive level, the IID confirms that U.S. principles will be applied to determine whether such instruments constitute debt or equity, irrespective of their treatment from a foreign perspective. On a procedural level, the IID illustrates the coordinated and focused approach that the IRS will take with respect to other Tier I issues in the IIF Program.

For further information, please contact any of the following lawyers:

Rocco Femia,, 202-626-5823

Marc Gerson,, 202-626-1475

Kimberly Majure

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