By Mario Polito and Crystel Saraie

The United States Internal Revenue Service (IRS) has issued new guidance that provides reassurance regarding the application of U.S. income tax treaties to widely used cross-border investment structures, particularly those involving reverse foreign hybrids. The guidance addresses longstanding uncertainty over the availability of treaty relief for foreign entities that are treated differently for U.S. and foreign tax purposes.

Reverse Foreign Hybrids and Treaty Mismatches

A reverse foreign hybrid is a foreign company that is treated as “transparent” for tax purposes in its home jurisdiction (i.e. its income is taxed at the level of its owners) but is treated as a corporation for U.S. tax purposes. This hybrid status can give rise to mismatches under U.S. tax law, such as unexpected taxes or limits on treaty benefits, particularly related to the branch profits tax (BPT) under Section 884 of the U.S. Internal Revenue Code.

Under U.S. tax law, the BPT is imposed on foreign corporations engaged in a U.S. trade or business, and applies to income deemed to be repatriated in the form of “dividend equivalent amounts” (DEAs). Historically, it has been unclear whether treaty-based reductions in the BPT were when a foreign entity is treated as a corporation in the U.S., even though it is transparent in its home country.

Key Issues Clarified by the IRS

1. Treaty Relief for Reverse Foreign Hybrids

The IRS guidance confirms that treaty benefits, particularly reduced BPT rates, can be available for income earned through a reverse foreign hybrid, provided that certain conditions (detailed below) are satisfied. [1] This clarification is significant for international investment structures where entities established in jurisdictions such as Luxembourg, Ireland, or the Netherlands serve as intermediary vehicles for investments into the United States.

2. Conditions for Accessing Treaty Relief

To qualify for reduced BPT rates or other treaty benefits, the following conditions generally must be met:

• Resident Owners: The owners of the reverse hybrid must be tax residents of the relevant treaty jurisdiction. [1]
  
• Fiscally Transparent Entity (FTE) Provisions: The relevant tax treaty must contain a “fiscally transparent entity” provision, typically based on Article 1(6) of the OECD Model Tax Convention. This provision ensures that income derived through a fiscally transparent entity is treated as derived by its owners for treaty purposes, as long as it is taxed in the owners’ country. [1]
  
• Limitation on Benefits (LOB): The treaty’s LOB article must be satisfied by the relevant owners. The LOB provision is designed to prevent treaty shopping and may require a showing that the owner is an individual, listed company, or meets other ownership and base erosion tests. [1]
  
• Documentation and Compliance: Proper documentation and treaty benefit claims must be filed in accordance with U.S. tax reporting requirements, including Forms W-8BEN-E or W-8IMY, as applicable. [1]

3. Treatment of Dividend Equivalent Amounts (DEA)

The new guidance confirms that:

• A reverse foreign hybrid that is treated as a corporation for U.S. tax purposes remains subject to U.S. corporate income tax on its effectively connected income (ECI). [1]
  
• The DEA subject to the BPT may nevertheless be reduced under an applicable treaty, based on the ownership share of qualifying treaty residents. [1]
  
• To the extent an owner does not meet the LOB or other treaty criteria, the related share of the DEA will qualify for the reduced BPT rates. [1]

Practical Implications for Investors

The new IRS guidance provides significant comfort for sponsors and institutional investors using on reverse hybrid structures to invest into the United States. In particular:

• It affirms that treaty relief may be available at the level of the reverse hybrid, as long as the economic owners are qualifying residents and proper documentation is in place.
  
• It offers a clearer framework for assessing exposure to the branch profits tax especially in multi-tier structures or when intermediary holding companies are involved.
  
• It removes a layer of legal uncertainty that has, in the past, led some investors to restructure unnecessarily to avoid potential tax leakage under U.S. domestic rules.

Sponsors and advisors should continue to ensure that structures are carefully reviewed in light of the relevant treaty terms, and that documentation is kept up to date to support any treaty claims.

This publication is distributed with the understanding that the author, publisher, and distributor of this publication and/or any linked publication are not rendering legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. Pursuant to applicable rules of professional conduct, portions of this publication may constitute Attorney Advertising. The choice of a lawyer is an important decision and should not be based solely upon advertisements.

[1] Internal Revenue Service. (2025, September 19). Application of treaties to branch profits tax of certain hybrid entities (Memorandum Number: AM2025-002). https://www.irs.gov/pub/lanoa/am-2025-002.pdf