Section 267A: Limitation on Hybrid Mismatch Deductions

Section 267A of the Internal Revenue Code, introduced in the 2017 Tax Cuts and Jobs Act (TCJA), is a provision designed to address tax avoidance by multinational corporations. It denies U.S. tax deductions for certain interest and royalty payments made between related entities when the payment structure exploits differences between U.S. and foreign tax laws. These structures are known as “hybrid mismatch arrangements.”

These arrangements can result in a payment being deducted by a U.S. entity without the corresponding income being taxed to the foreign recipient, or the same expense being deducted in two different countries. Section 267A confronts these outcomes by disallowing the U.S. deduction that creates the tax mismatch. This rule aligns the U.S. with international efforts to combat base erosion and profit shifting, reflecting a global trend toward closing tax loopholes.

Core Concepts and Definitions

The rule’s scope is defined by several key terms, starting with a “related party.” For the purposes of this rule, the definition is based on the rules for controlled foreign corporations. Section 267A only applies to payments between entities that are part of the same controlled group.

The rule specifically targets payments of “interest and royalty.” Interest is compensation for the use of money, while royalties are payments for the right to use intangible assets like patents or trademarks. These two payment types are the focus because they were commonly used in structures that exploited international tax differences.

A “hybrid transaction” is one treated differently for tax purposes by the U.S. and a foreign country. For example, a financial instrument may be viewed as debt by the U.S., allowing the payer to deduct interest payments. The foreign recipient’s country might classify the same instrument as equity, treating the payments as tax-exempt dividends.

A “hybrid entity” has a different tax status in the U.S. and a foreign country. For instance, the U.S. might treat a Limited Liability Company (LLC) as a pass-through entity, while a foreign country may view it as a separate corporation. This dual status can be used to create tax advantages that Section 267A seeks to prevent.

An interest or royalty payment made within a hybrid arrangement that results in a tax mismatch is called a “disqualified related party amount.” This is the official term for the payment for which a U.S. tax deduction is denied under Section 267A. The denial of the deduction is the direct mechanism by which the rule neutralizes the tax benefit.

Identifying a Hybrid Mismatch

A deduction is disallowed under Section 267A if a payment results in either a “Deduction/No-Inclusion” (D/NI) outcome or a “Double Deduction” outcome. These are the two primary scenarios the rule targets.

A D/NI outcome occurs when a U.S. entity makes a deductible interest or royalty payment to a related foreign party, but the payment is not included in the recipient’s gross income under its country’s tax laws. This mismatch undermines the principle that a deduction in one jurisdiction should correspond to an income inclusion in another.

An example of a D/NI outcome involves a hybrid financial instrument. A U.S. subsidiary might borrow from its foreign parent using an instrument the U.S. classifies as debt, allowing for deductible interest payments. If the foreign parent’s country classifies the instrument as equity, the payments are treated as tax-exempt dividends, resulting in a U.S. deduction with no foreign income inclusion.

The “double deduction” outcome occurs when a single economic expense generates a tax deduction in two different countries. This can happen when a payment is made by a hybrid entity, which is treated as a taxable corporation in one country but as a pass-through entity in another.

For example, a U.S. entity might make a deductible interest payment to a third-party lender and claim a deduction on its U.S. tax return. If a foreign parent company’s country views the U.S. entity as a branch, the foreign parent may also be permitted to deduct the same interest expense under its local laws. Section 267A prevents this by disallowing the deduction at the U.S. entity level.

The Imported Mismatch Rule

The “imported mismatch rule” extends Section 267A beyond direct payments to prevent taxpayers from using an intermediary entity in a third country to bypass the rules. This provision “imports” the tax consequences of an offshore hybrid arrangement to deny a U.S. deduction for a payment that might otherwise seem compliant.

The rule applies when a U.S. entity makes a deductible interest or royalty payment to a related foreign party (Foreign Company 1), and that payment is fully taxable under its local laws. Although this transaction alone would not trigger Section 267A, the rule requires looking at subsequent transactions.

The imported mismatch rule is triggered if Foreign Company 1 uses that income to make its own deductible payment to another related party (Foreign Company 2) as part of a separate hybrid arrangement. If the payment from Foreign Company 1 to Foreign Company 2 results in a deduction for Foreign Company 1 but is not included in Foreign Company 2’s income, an offshore D/NI outcome has occurred. The rule connects this offshore arrangement back to the original U.S. payment.

For instance, a U.S. company pays fully taxable interest to its subsidiary in Country A (Foreign Co 1). Foreign Co 1 then uses those funds to make a deductible interest payment on a hybrid instrument to its subsidiary in Country B (Foreign Co 2), where the payment is treated as a tax-exempt dividend. The imported mismatch rule allows the IRS to disallow the original interest deduction claimed by the U.S. company to the extent the income was offset by the hybrid payment made by Foreign Co 1.

Compliance and Documentation Requirements

A U.S. taxpayer seeking to deduct an interest or royalty payment to a related foreign party bears the burden of proving the payment is not disallowed under Section 267A. This requires substantiating that no hybrid mismatch exists through proactive compliance and documentation.

Taxpayers must conduct a detailed analysis of the relevant foreign tax law to determine how the foreign jurisdiction treats the payment, the instrument, and the entities. This includes confirming whether the foreign recipient must include the payment in its taxable income and how the foreign country characterizes the transaction.

To support their position, taxpayers must also gather specific documentation from the foreign recipient. This can include copies of the foreign party’s tax returns showing the income inclusion, financial statements that corroborate the tax treatment, or other official tax records.

The compliance process involves a comprehensive review of the entire transaction structure. Taxpayers need to document their analysis of the relationship between the parties, the characterization of entities and instruments under both U.S. and foreign law, and the flow of funds. For complex structures, this analysis must extend to indirect payments and offshore arrangements. Maintaining this detailed file is necessary to defend the deduction if it is challenged by the IRS.