Application of income tax treaties to branch profits tax of certain hybrid entities

The IRS publicly released a legal advice memorandum* (from the Office of Chief Counsel) addressing, in the scenario described below, the extent to which relief is available under a U.S. income tax treaty from the branch profits tax under section 884 imposed in respect of business profits earned by a foreign entity that is fiscally transparent for foreign tax purposes but treated as a corporation for U.S. tax purposes.

Scenario

RFHX, an entity formed under the laws of Country X, is taxable as a corporation under U.S. law and is treated as fiscally transparent under the laws of Countries X, Y, and Z. RFHX has a single class of equity interests, with four equal owners as of the close of its tax year at issue:

• A, an individual resident in Country Y
• B, a corporation organized under the laws of, and tax resident in, Country Y, the principal class of shares of which has been regularly and primarily traded on a Country Y recognized stock exchange for more than twelve consecutive months as of such date
• C, a privately held corporation organized under the laws of, and tax resident in, Country Y, all the shares of which are owned by individuals resident in Country Z, and have been for more than half of the days of any twelve-month period that includes such date
• D, an individual resident in Country Z

Each owner has been a resident in its respective country for more than twelve consecutive months as of the close of RFHX’s tax year at issue.

RFHX’s income is effectively connected with a U.S. trade or business. All of that income is subject to corporate tax of 21% under sections 11 and 882. Additionally, absent any treaty relief, RFHX is also subject to the branch profits tax of 30% under section 884. RFHX distributes all of its income to its owners as earned and does not reinvest any of it in its U.S. business. Thus, the “dividend equivalent amount” (DEA) to which the branch profits tax applies generally is the same as its net income.

The United States has a bilateral income tax treaty in force with Country Y, but not with Country X or Country Z. The U.S.-Country Y treaty is worded consistently with the 2016 United States Model Income Tax Convention (2016 Model) and provides that an item of income, profit or gain derived by or through an entity that is treated as fiscally transparent under the taxation laws of Country Y shall be considered to be derived by a resident of Country Y only to the extent that the item is treated for purposes of the taxation laws of Country Y as the income, profit or gain of a Country Y resident. Additionally, the treaty provides for a reduction in the rate of branch profits tax if the company with the relevant U.S. permanent establishment (PE) has been a resident of Country Y (or a qualifying third State) for the twelve-month period ending on the date on which the entitlement to the DEA is determined (“BPT provision”).  The U.S.-Country Y treaty contains a limitation on benefits provision (“LOB provision”) that must be satisfied in order to obtain the reduction in branch profits tax.

RFHX’s income is business profits attributable to a U.S. PE under the U.S.-Country Y treaty. None of the owners of RFHX has a separate PE in the United States. RFHX complies with applicable U.S. reporting requirements and satisfies its U.S. tax obligations, including with respect to corporate income tax and branch profits tax. It also meets any applicable documentation requirements associated with claiming a reduced rate of branch profits tax on its DEA.

Conclusion

The IRS concludes in the scenario presented that RFHX is subject to:

• Corporate income tax at the applicable rate (currently, 21%) under sections 11 and 882 on its income that is effectively connected with a U.S. trade or business and which is business profits attributable to its U.S. permanent establishment (PE) for treaty purposes
• Branch profits tax on a DEA relating to such profits, but RFHX is entitled to a reduction in the rate of branch profits tax to the extent that the DEA corresponds to the percentage interest of an owner in the profits or income of the taxpayer (as determined under the law of the owner’s state of residence) as of the close of the taxpayer’s tax year, provided that such owner:
  • Is taxable on profits or income earned through RFHX under the laws of Country Y as a resident;
  • Has been a resident of Country Y for more than twelve continuous months (applying the BPT provision at the RFHX-owner level); and
  • Satisfies the applicable LOB provision under the U.S.-Country Y treaty

Thus, RFHX is entitled to a reduced rate of branch profits tax on the portion of the DEA corresponding to interests held by A and B, but RFHX must pay a 30% rate of branch profits tax on the portion of the DEA corresponding to interests held by C (because it does not satisfy the LOB provision) and D (because it is not a resident of Country Y). The result would be the same if RFHX were organized in, but still treated as fiscally transparent under, the laws of Country Y.

Read AM 2025-002 (release date of September 19, 2025, and dated September 8, 2025)

* Legal advice memoranda are signed by executives in the National Office of the Office of Chief Counsel and issued to Internal Revenue Service personnel who are national program executives and managers. The memos are issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. The memos cannot be used or cited as precedent.