Hybrid Entities in Tax Treaty Law

S. 721. Setting the Scene: US international tax issues regarding hybrid entities

Throughout its tax treaty history, the United States of America (US) has entered into more than 50 Double Tax Conventions (DTCs) with foreign jurisdictions. In doing so, the US has followed its own tax treaty policy and has developed its own Tax Model Convention (US Model) as its individual instrument for DTC negotiation. The current version of the US Model is the 2016 US Model, which replaced the previously in-force 2006 US Model.

During the development of its tax treaty policy, the US has acknowledged the possibility of the improper use of a DTC and has addressed it in its tax treaty practice. In this regard it has been stated that:

Nonetheless, multiple cases of hybrid mismatches have arisen in the US deriving from the check-the-box regulations under US domestic law, which provide for an elective system for classifying entities for tax purposes between transparent or opaque entities, subject to a series of specific rules and limitations. As a response to hybrid mismatch situations, the US developed and included a hybrid entity provision in the 1996 US Model, maintaining it in the 2006 and 2016 US Models and introducing it into its treaty practice (e.g., US-United Kingdom and US-Germany DTCs). The US Model’s hybrid entity provision has proven to be highly influential in the international tax scenario, playing an important role as a direct precedent to the OECD and UN Models’ hybrid entity clauses.

Centering on this influential role, the present work seeks to understand the treatment of hybrid entities under the US Model, the main policy reasons behind such hybrid entity rules and the main practical implications. To this end, Section 2 starts by examining the relevant provisions relating to hybrid entities under US domestic tax law. Section 3 continues with an in-depth analysis of the US Model’s hybrid entity provision. Section 4 analyzes the relationship between S. 73the US Model, and the OECD and UN Model’s treatment of hybrid entities. The work concludes in Section 5 with critical remarks and brief conclusions by the author.

2. General Treatment of Hybrid Entities under US Domestic Law

2.1. US “Check-the-Box” Regime and hybridity issues

First, it should be noted that in 1996 the US issued the check-the-box regulations for the characterization of entities for tax purposes. As stressed by McDaniel, Repetti and Ring, the US income tax system is applicable to corporations, partnerships, trusts, and certain hybrid entities, and thus it is important to determine the proper classification for income tax purposes of a particular entity. As per these authors, the check-the-box system can be summarized in the following way: i) certain entities are always classified as corporations. The owners of these “per se” corporations are not allowed to elect a different classification. In the domestic context, the per se corporations include the following: domestic corporation (under federal or state statutes), insurance company, insured bank, a government-owned entity. In the foreign context, certain entities such as the Aktiengesellschaft in Germany and the Societé Anonyme in France are classified as per se corporations.; ii) if a domestic entity is not classified as a per se corporation under the previous rules, it is treated by default either as a partnership if it has two or more owners or as a branch if it has one owner;; iii) the owner(s), however, may elect to have the entity treated as a corporation in accordance with Treasury Regulations Section 301.7701-3(a), (b)(1); iv) if a foreign entity is not classified as a per se corporation under the above rules, it is classified pursuant to default rules either as a partnership if it has two or more owners and at least one of them does not have limited liability or as a corporation if all of its owners have limited liability. The determination whether an owner has limited liability is made by reference to the law of the country under which the entity is organized. However, the owners of such a foreign entity may elect an alternative treatment if they desire a classification other than that provided by the default rules. For example, if the entity is classified as a corporation but the owner(s) desires to have it classified as a partnership or branch.

S. 74In accordance with the check-the-box regulations, the entity classification for tax purposes under US domestic law consists of an elective system subject to a series of rules and limitations. One result of this elective regime is an increased number of situations in which the US classifies an entity as a partnership or branch and another country classifies it as a corporation, or vice-versa.

Regarding the tax treatment of a partnership, McDaniel, Repetti and Ring note that under US tax principles, a partnership is not treated as a separate taxpaying entity. Partnership income and deductions “flow through” to the individual partners, whether they are individuals or entities, and are taxed to them in accordance with the applicable principles. The partnership itself is treated as an accounting entity for purposes of computing the partnership’s net income or loss which is then apportioned to its partners. Accordingly, the partnership must file a tax return which fundamentally operates as an information return with respect to the items of partnership income and deduction. Rules governing partnerships are set forth in Sections 701-761 of the US Internal Revenue Code (IRC). The US partnership taxation rules are of great importance because said rules are applicable to entities which have elected to be treated as a partnership for tax purposes pursuant to the described check-the-box regulations.

2.2. Tax Treaty applicability for partnerships and fiscally transparent entities

As it has been explained in this volume, by deriving income through a hybrid entity, a taxpayer may be able to take advantage of the different tax regimes of two jurisdictions in order to avoid or reduce the taxation of such income.

With the proliferation of hybrid entities in the US, the US Internal Revenue Service (IRS) and the US Department of the Treasury (US Treasury) had to regulate the treaty eligibility of hybrid entities deriving passive income. Likewise, US Congress acknowledged this specific situation and aimed to tackle it by enacting a new Section 894(c) to the IRC. In the legislative history to Section 894(c) the Committee on the Budget of the US House of Representatives pointed out the necessity of a limitation on treaty benefits for income derived through hybrid entities:

Moreover, the Committee on the Budget of the US House of Representatives expressed the position that the potential tax-avoidance opportunities available for foreign persons that invest in the US through hybrid entities, specifically for the case of the US-Canada DTC, should be eliminated. To reduce these type of tax avoidance opportunities, the US Treasury Department proposed the new regulations under Section 894 of the IRC. Finally, on August 5, 1997 the Taxpayer Relief Act of 1997 added Section 894(c) to the IRC.

Section 894 of the IRC expressly prohibits a foreign person from receiving, under any income tax treaty with the US, a reduced rate of US withholding tax on an item of income derived through an entity that is treated as a partnership (or is otherwise treated as fiscally transparent) if: (A) such item is not treated for purposes of the taxation law of such foreign country as an item of income of such person, (B) the treaty does not contain a provision addressing the applicability of the treaty in the case of an item of income derived through a partnership, and (C) the foreign country does not impose tax on a distribution of such item of income from such entity to such person.

In this regard, the US has followed the rules set forth in the above-mentioned Section 894 of the IRC in the text of the US Model, as will be further detailed in Section 3. Likewise, US treaty practice is intended to follow the principle set forth in Section 894 of the IRC.

Regarding the treatment of the use of hybrid entities in the US, McDaniel, Repetti and Ring state that hybrid entities (as well as hybrid instruments) often pose S. 76challenges for the tax system. Although sometimes these issues are entirely domestic, for them many of the most attractive uses of hybrids occur in the cross-border context, particularly with the application of treaties. Taxpayers could use hybrid entities to avoid having any tax (US or foreign) apply to income. The authors further discuss the issue whereby income earned by a US entity, taxable as a partnership for US purposes, might not be taxable because of favorable treaty provisions that would apply to foreign partners in the partnership.

The US Treasury has intended to solve some treaty issues with hybrids through the application of Section 894(c) and the regulations thereunder. In this regard, US Treasury Regulations Sec. 1.894-1(d)(2)(i) define a “domestic reverse hybrid entity” as a domestic (i.e., US) entity that is treated as not fiscally transparent for US tax purposes, and as fiscally transparent under the laws of the interest holder’s jurisdiction, with respect to the item of income received by the domestic entity.

Based on US Treasury Regulations Sec. 1.894-1(d)(2)(i), a hybrid entity from the US perspective is an entity that is fiscally transparent for US tax purposes but opaque for foreign tax purposes, such as a US LLC that is treated as a corporation in another jurisdiction. On the other hand, a “reverse hybrid entity” from the US perspective is an entity that is opaque (i.e., a separate taxpayer) for US tax purposes but fiscally transparent for non-US tax purposes, such as a foreign partnership that elects to be treated as a corporation for US tax purposes according to the “check-the-box” regulations. It is important to note that the US utilizes a different definition for hybrid entities and reverse hybrid entities from the internationally accepted terms, as stressed by Floren.

Regarding the above-mentioned regulations, McDaniel, Repetti and Ring point out that: the residence state tax characterization of an item of income for the cases S. 77of entities that are not domestic reverse hybrid entities will generally control for purposes of applying a treaty. Moreover, following McDaniel, Repetti and Ring, the treatment of an entity that is a domestic reverse hybrid entity is more complex and depends on whether the domestic reverse hybrid entity is receiving or making a payment. With respect to payments received by domestic reverse hybrid entities, the regulations state that a tax treaty cannot reduce the tax applied to such payments that are from a US source. Thus, even though another country might tax a person holding an interest in the domestic reverse hybrid entity upon the entity’s receipt of US source payments, the US will not apply the treaty rates to such person’s share of the income received by the domestic reverse hybrid entity. On the other hand, payments from the domestic reverse hybrid entity will be characterized for treaty purposes as paid by a non-transparent entity.

Following Lipton, Carman, Fassler and Schwidetzky, US tax imposed on payments to foreign persons of items of income received by an entity that is fiscally transparent under the laws of the US and/or any other jurisdiction is eligible for a reduction of US tax under the terms of a US income tax treaty only if the item of income is derived by a resident of the applicable treaty jurisdiction. In this regard, an item of income may be derived by either the entity receiving the item of income or by the interest holders in the entity, or both. An item of income is considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity’s jurisdiction. An item of income paid to the entity is considered to be derived by the interest holder in the entity only if the interest holder is not fiscally transparent in its jurisdiction, and the entity is fiscally transparent in the interest holder’s jurisdiction. Moreover, as aforementioned, an income tax treaty may not apply to reduce the amount of US federal income tax on US-source payments received by a domestic reverse hybrid entity. The foreign interest holders of a domestic reverse hybrid entity are not entitled to the benefits of a reduction of US income tax under an income tax treaty on items of income received from US sources by such entity.

For example, if A and B, both residents of Canada, formed a Delaware limited partnership AB, and AB elected to be taxed as a corporation in the US, AB would not be fiscally transparent for US tax purposes but would be fiscally transparent for Canadian tax purposes. A and B would not be eligible for treaty S. 78benefits on payments to AB. Similarly, subject to some exceptions, an item of income paid by a domestic reverse hybrid entity to an interest holder in such entity has the character of such item of income under US law and is considered to be derived by the interest holder, provided the interest holder is not fiscally transparent in its jurisdiction with respect to the item of income. In determining whether the interest holder is fiscally transparent with respect to the item of income, the determination is to be made based on the treatment that would have resulted had the item of income been paid by an entity that is not fiscally transparent under the laws of the interest holder’s jurisdiction with respect to any item of income.

2.3. Deductibility of interest and royalty payments in hybrid transactions after BEPS Action Plan No. 2

The OECD Base Erosion and Profit Shifting Project (BEPS) Action 2 seeks to develop model treaty provisions and recommendations regarding the design of domestic rules to neutralize the tax effects of hybrid instruments and entities. BEPS Action 2 has, among its objectives, to reduce the incidence of mismatches in tax outcomes that arise in respect of payments made under a hybrid financial instrument or payments made to or by a hybrid entity.

BEPS Action 2 proposes a “Primary Rule” and a “Secondary Rule” for hybrid transactions and entities. Under the Primary Rule, a Contracting State should deny a taxpayer’s deduction for a payment, to the extent that it is either not included in the taxable income of the recipient in the other Contracting State or when it is also deductible in the other Contracting State. Under the Secondary Rule, if the Primary Rule is not applied, then the other Contracting State should require the deductible amount to be included as taxable income or should deny the duplicate deduction.

Accordingly, the 2017 US Tax Reform Act introduced a new Section 267A on the IRC as a response to BEPS Action 2. In general terms, the provision eliminates U.S. deductions for interest and royalty payments made to any foreign related party (including foreign hybrid entities) in a hybrid transaction where the payments are not included in the income of the foreign recipient of the payment.S. 79This provision is applicable to reverse hybrids as well as to hybrids, and seeks to tackle Deduction/Non-Inclusion situations.

3. Hybrid entities under the US Model Convention

3.1. Overview and tax policy history of the US Model Convention

Regarding the early tax treaty development in the US, Vogel, Shannon and Doernberg identify two general principles: on the one hand, the US seeks to harmonize US treaty practice with the practice in other states. Consequently, from the outset, US treaties have reflected the provisions of the prevailing international models. Early treaties reflect provisions of the League of Nations models and more recent treaties reflect provisions of the OECD and UN Models. On the other hand, the US seeks to preserve domestic tax treatment of citizens and residents in the treaty context. Based primarily on this policy, numerous aspects of US practice deviating from the prevailing international models have emerged.

With regards to the development of the US Model, Vogel, Shannon III and Doernberg note that when the US began expanding its treaty network following World War II, US Treasury developed an unofficial model treaty (which followed the US-UK treaty of 1945) to use as a basis for treaty negotiations. This initial model was constantly modified and revised based on the different treaty negotiation experiences with other states. This early unofficial model was for internal use by US treaty negotiators and was not published or made available to the public and, despite an important level of conformity between the US treaty practice and the OECD Model, the OECD Model did not replace the unofficial US model for US tax treaty purposes. Then in 1976, the US Treasury decided to make the US Model available to the public. US Model evolution indicates that it was conceived as a non-static document. Accordingly, the US Model has been amended and updated when necessary, as per US tax policy goals.

S. 80As Vogel, Shannon III and Doernberg continue to state, since the OECD Model emphasized the priority of residence state taxation over source state taxation, the adoption of many of the OECD standards was consistent with US treaty policy. The authors note that a basic foundation of US treaty policy is that double taxation should be avoided primarily by limiting source state taxation of foreign residents and that treaty limitations on the right of a state to tax its citizens and residents should occur only in exceptional cases.

Relating to the US Model purpose, some authors have expressed their views that the model is aimed to constitute a starting point for US tax treaty negotiations. Conversely, other commentators have suggested that rather than treating the US Model simply as the starting point for treaty negotiations, it should be understood as the goal of US tax treaty negotiations.

As can be concluded from the different US Model versions and the specific US treaty practice, the general policy approach of the US when negotiating bilateral tax treaties has been the position of prioritizing the residence state’s right to tax. Consequently, the US favored mechanism for avoiding double taxation consists of reducing the right to tax of the source state. This US policy perspective has generally been aligned with the OECD Model which favors residence state taxation over source state taxation. However, as Vogel, Shannon III and Doernberg note:

As of today, the latest versions of the US Model published by the US Treasury Department consist of the 1996 US Model, the 2006 US Model, and the 2016 US Model, which is the current version. Moreover, it should be noted that the latest Technical Explanation available corresponds to the 2006 US Model Technical Explanation, since the 2016 US Model Technical Explanation has not yet been published.

S. 81Moreover, the US has tried to address treaty abuse with hybrid entities. McDaniel, Repetti and Ring note that according to the US Model:

Following the cited authors’ analysis and examples, in the case that a US corporation pays a dividend to a foreign entity which is treated as fiscally transparent in the other state, the participants in the entity who are treaty country residents will be entitled to the benefits of the treaty even if, under US law, the entity itself had been the relevant taxpayer. Similarly, if a US payer makes a payment to an entity that the US treats as fiscally transparent but the other jurisdiction treats as a corporation, treaty relief will depend on whether the income is liable to tax in the treaty country in the hands of the entity.

Moreover, it should be noted that in the tax treaty scenario, the US has advocated for the position that income derived through a fiscally transparent entity should be entitled to treaty benefits only to the extent that the income is attributed to and taxable in the hands of a resident, as Yonah and Tittle stress. Consequently, the 1996 US Model introduced a provision dealing with income derived through a fiscally transparent entity in the above-mentioned terms.

In this regard, Yonah and Tittle note that the US was able to persuade the OECD to endorse this position regarding fiscally transparent entities, as indicated by the changes to the OECD Commentary on Article 1. The Commentary to the 2000 OECD Model introduced a section regarding the application of the Convention to partnerships, and afterwards, the Commentary to the 2005 OECD Model included several new paragraphs dealing with the treatment of fiscally transparent entities. The OECD finally introduced a hybrid entity provision in Article 1(2) of the 2017 OECD Model, the wording of which is primarily based on Article 1(6) of the US Model.

S. 823.2. The hybrid entity provision under the US Model Convention

At the international level, the 1999 OECD Partnership Report constitutes one of the starting points for the inclusion of provisions regarding hybridity in tax conventions. However, the US was dealing with hybrid entity issues before the Partnership Report was issued. In this regard, Parada notes that:

In this way, US treaty practice and the subsequent introduction of the hybrid entity provision in the US Model constitute a crucial precedent for the international tax law treatment of hybrid entities. The 1996 US Model was the first treaty model to incorporate a hybrid entity provision in Article 4(1)(d) and which established the following:

Moreover, the 2006 US Model included the same wording but moved it from Article 4 (Residence) to Article 1 (General Scope), specifically to its paragraph 6. This wording constitutes the general hybrid entity rule and is based on the premise that treaty benefits for fiscally transparent entities should be granted based on the treaty eligibility of the person deriving the income, as defined by the domestic tax law of said person’s state (residence state).

In the same line, the 2016 US Model Article 1(6) establishes the following:

S. 83As can be seen, the 2016 US Model has some differences in wording with the wordings of the 1996 and 2006 US Model. In general, these additions constitute a more precise wording that aims to clarify potential misinterpretations; however, the provision remained the same from a substantial point of view. Regarding the change in the wording, Parada argues that:

Moreover, it is important to understand that the hybrid entity provision operates as an income allocation rule for tax treaty purposes. In this regard, in application of Article 1(6) of the 2016 US Model an item of income derived through a transparent entity will be considered to be derived by a resident of a Contracting State – provided it is treated as income of a resident of such State as per the State’s domestic law – and thus, the tax treaty benefits may be applicable. Consequently, the hybrid entity provision is applicable as an income allocating rule even if both contracting states treat the entity as fiscally transparent.

Following the 2006 US Model Technical Explanation to Article 1(6), the US Treasury has acknowledged that there is a high risk of double taxation and double non-taxation derived from the fact that countries frequently adopt different views regarding when an entity is fiscally transparent.

In this regard, Article 1(6) of the 2016 US Model is applicable to fiscally transparent entities such as partnerships and certain estates and trusts, and has two main objectives: i) to eliminate a number of technical problems that may have prevented investors using such entities from claiming treaty benefits, even though such investors would be subject to tax on the income derived through such entities, and ii) to prevent the use of such entities to claim treaty benefits in circumstances where the person investing through such an entity is not subject to tax on the income in its State of residence. It is with these two goals in mind that one should read and interpret Article 1(6) and the substantive rules of Articles 6 through 21 of the US Model.

Article 1(6) is applicable to any resident of a Contracting State who is entitled to income derived through an entity that is treated as fiscally transparent under the S. 84laws of either Contracting State. The 2006 US Model Technical Explanation clarifies that entities falling under this description in the US include partnerships, common investment trusts under Section 584 and grantor trusts, as well as LLCs that are treated as partnerships or as disregarded entities for US tax purposes.

The following examples of the application of Article 1(6) from the US perspective are presented in the 2006 US Model Technical Explanation: i) if a company that is a resident of the other Contracting State pays interest to an entity that is treated as fiscally transparent for US tax purposes, the interest will be considered derived by a resident of the US only to the extent that the taxation laws of the US treats one or more US residents (whose status as US residents is determined, for this purpose, under US tax law) as deriving the interest for US tax purposes; ii) in the case of a partnership, the persons who are, under US tax laws, treated as partners of the entity would normally be the persons whom the US tax laws would treat as deriving the interest income through the partnership; iii) persons whom the US treats as partners but who are not US residents for US tax purposes may not claim a benefit for the interest paid to the entity under the treaty, because they are not residents of the US for purposes of claiming this treaty benefit; iv) for the case of an entity organized under US laws and classified as a corporation for US tax purposes, interest paid by a company that is a resident of the other Contracting State to the US entity will be considered derived by a resident of the US since the US corporation is treated under US taxation laws as a resident of the US and as deriving the income.

The 2006 US Model Technical Explanation clarifies that the same results arise even if the entities were viewed differently under the tax laws of the other Contracting State (e.g., as not fiscally transparent in the first example above where the entity is treated as a partnership for US tax purposes). Likewise, the characterization of the entity in a third country is irrelevant, even if the entity is organized in that third country. The results follow regardless of whether the entity is disregarded as a separate entity under the laws of one jurisdiction but not the other, such as a single owner entity that is viewed as a branch for US tax purposes and as a corporation for tax purposes under the laws of the other Contracting State. These results are also obtained regardless of where the entity is organized (e.g., either in the US, in the other Contracting State, or in a third country).

3.3. Key aspects of the hybrid entity provision of the US Model Convention

In this section, reference is made to the key aspects of the wording of the 2016 US Model hybrid entity provision:

S. 853.3.1. An item of income, profit or gain

Article 1(6) of the 2016 US Model refers to an item of income, profit or gain derived by or through a fiscally transparent entity. The inclusion of income, profits and gains is aimed at covering all the different categories of earnings regulated by Articles 6 to 21 of the 2016 US Model (e.g., business profits, dividends, interest, royalties, gains, etc.).

In comparison, Article 1 (2) of the 2017 OECD Model refers exclusively to income. However, the Commentary to Article 1 of the 2017 OECD Model sets forth in paragraph 8 that the word ‘income’ must be given a wide meaning in order to cover the different items dealt with by Chapter III of the OECD Model (Taxation of Income). In this regard, the 2016 US Model hybrid entity provision covers all types of income, profits and gains regulated by the 2016 US. Moreover, since the US Model does not have a provision for the taxation of capital, there is no need to include capital in the hybrid entity provision.

3.3.2. Derived by or through

Article 1(6) of the 2016 US Model refers to income derived by or through a fiscally transparent entity. This represents one of the changes in wording from the previous 2006 US Model, which referred to income derived through a fiscally transparent entity.

Following Parada, the terms ‘by’ and ‘through’ are, in principle, utilized in an interchangeable manner. As he also suggests, in the absence of a 2016 US Model Technical Explanation, the concrete reasons of the change in wording are not completely clear. However, clarity can be found in the Commentary to Article 1 of the 2017 OECD Model which includes the same reference to “derived by or through”.

S. 86Following the explanation of Paragraph 7 of the Commentary to Article 1 of the 2017 OECD Model, the reference to derived by or through has a broad meaning intended to cover any income derived by or through a fiscally transparent entity, regardless of the view taken by each Contracting State as to who derives that income for domestic tax purposes and regardless of whether or not the entity has legal personality or constitutes a person as duly defined in the Convention.

Therefore, the provision should be applicable to cases where a Contracting State treats the entity deriving the income as transparent, thus income is derived through the entity, and to cases where a Contracting State treats the entity deriving the income as opaque, thus income is derived by the entity.

In addition, note that Article 3(1)(c) of the 2016 US Model establishes that the terms “enterprise of a Contracting State” and “enterprise of the other Contracting State” mean, respectively, an enterprise carried on by a resident of a Contracting State, and an enterprise carried on by a resident of the other Contracting State. The definition expressly states that the terms also include an enterprise carried on by a resident of a Contracting State through an entity that is treated as fiscally transparent in that Contracting State.

3.3.3. Wholly or partly fiscally transparent

The 2016 US Model refers to wholly or partly fiscally transparent entities, in the exact same way the 2017 OECD Model is worded. This represents a change from the previous 2006 US Model, which referred to a fiscally transparent entity.

As indicated by paragraph 9 of the Commentary to Article 1 of the 2017 OECD Model, the provision is set to cover situations where, under the domestic tax law of one of the contracting states, income or part of the income of an entity is not taxed at the level of the entity but is taxed at the level of the persons who have an interest in that entity. Therefore, the provision is applicable to entities that are fiscally transparent as a whole or partially transparent, with respect to a specific item of income, profit, or gain. The 2006 US Model Technical Explanation to Article 1 Paragraph establishes that entities falling under the fiscally transparent category in the US include partnerships, common investment trusts under section 584 and grantor trusts, as well as LLCs that are treated as partnerships or as disregarded entities for US tax purposes.

On another line, note that the 2016 US Model contains reference to fiscally transparent entities in Article 10(2)(a)(ii)(A) relating to the treatment of dividends and on Article 22(7)(e)(i)(C) with regards to the Limitation on Benefits provision. The specific analysis of those provisions is out of the scope of this work.

S. 873.4. The relationship with the “saving clause” of the US Model Convention

One consistent trait of US tax policy has been the position that the US should continue to be allowed to tax its residents and citizens even after a tax treaty has come into effect. In other words, that a tax treaty should not prevent the US to continue taxing its residents and citizens. Based on the above, the US has consistently included a provision in these lines in its tax treaties, the so-called saving clause. In this regard, Article 1(4) of the 2016 US Model establishes the saving clause in the following way:

As it reads, the only exceptions for the applicaction of the saving clause are contained in Article 1(5) of the 2016 US Model. Therefore, an important takeaway is that Article 1(6) of the US Model (the analyzed hybrid entity clause) is not an exception to the application of Article 1(4) of the US Model (the saving clause). Thus, by applying the saving clause, the US may tax items of income derived by a US citizen or resident to which a specific tax treaty article allocates exclusive taxing rights to the source state.

Moreover, Kofler indicates that from a US perspective, the saving clause comes to preserve and save the US’ basic principle of taxing the worldwide income of its resident individuals (regardless of their nationality), its citizens (regardless of their residence), and its corporations. Relating to the effects of the saving clause, Kofler states that:

When analyzing the interplay between the hybrid entity clause and the saving clause, it should be noted that the hybrid entity clause does not prevent a Contracting State to tax an entity that is a resident of said State according to its domestic tax law. In this line, the 2006 US Model Technical Explanation on Article 1 Paragraph (6) presents the following example: if a US LLC with members who are residents of the other Contracting State elects to be taxed as a corporation for US tax purposes, the US will have the right to tax the LLC on its worldwide income on a net basis, regardless if the other Contracting State views the LLC as fiscally transparent.

3.5. Example of the application of the hybrid entity provision of the US Model Convention

The following provides examples of the specific application of the US Model hybrid entity provision:

Assume X is an entity formed in State X, from where it is a tax resident. X is owned by A and B (US residents). X receives X State-source royalty income. X is treated as a taxable corporation in State X, and as a transparent partnership in the US. There is a tax treaty based on the US Model between the US and State X.

In this case, since X is transparent for US purposes, the royalty income is effectively derived through a transparent entity up to A and B. The US will attribute S. 89said income to A and B who are US residents. Thus, in application of the hybrid entity provision, royalty income arising in Sate X is considered to be derived by A and B, and the US-X tax treaty is applicable for A and B purposes. Under this scenario, the hybrid entity provision grants access to treaty benefits to the US owners.

Now assume a US partnership has two owners (A and B) who are US citizens. Interests are paid to the partnership from State P. The partnership is treated as transparaent for US tax purposes, and as a taxable entity for State P tax purposes. There is a tax treaty based on the US Model between the US and State P.

In this case the different characterization of the US partnership by each state is solved by the hybrid entity provision in a similar way to the previous case. Since US P is transparent for US tax purposes, the income is considered to be derived through a transparent entity up to A and B, who are US citizens and would be taxed over the income in the US. Therefore, interest arising in State P is considered to be derived by A and B, and the US-P tax treaty is applicable for A and B purposes.

As Parada notes, the solutions of Article 1(6) of the US Model relating to who should be entitled to treaty benefits in situations where income is derived by or through an entity considered to be fiscally transparent for at least one of the contracting states will not always be aligned with Articles 10, 11 and 12 of the US Model that require the beneficial owner of the income to be a resident of the other S. 90Contracting State.^, In this regard, the above-mentioned solutions should be understood as a strict application of the hybrid entity provision for tax treaty elegibility purposes, and questions regarding its interplay with the beneficial ownership concept remain unresolved.

4. The relationship between the hybrid entity provision of the US Model Convention and other Tax Model Conventions

As has been stated, US tax treaty policy has included the position that income derived through a fiscally transparent entity should be entitled to treaty benefits, provided that said income is attributed to and taxable in the hands of a resident. In this regard, before the 1999 OECD Partnership Report, the US was already including a hybrid entity provision in its tax treaties, and they included the hybrid entity provision in their 1996 US Model. This approach heavily influenced the international tax landscape, which eventually started to catch up with the policy of including a hybrid entity provision, and (also) a saving clause on tax models and treaties. The adoption of the hybrid entity provision (as well as the saving clause) by the OECD and UN Models took place several years after the early development of these provisions under US tax policy. In this respect, the OECD finally introduced a new Article 1(2) dealing with hybrid entities in the 2017 OECD Model.

The 2017 OECD Model hybrid entity provision is strongly influenced by the US Model, and their language and principles are remarkably similar, with some slight wording differences. However, it should be acknowledged that even with very similar hybrid entity provision in DTCs and tax treaties, the practical application of the provision and its interplay with the saving clause, the beneficial ownership concept and the double taxation relief method provision still present major challenges for the international tax system.

With regards to the United Nations Model Double Taxation Convention between Developed and Developing Countries (UN Model), it should be noted that the development of the hybrid entity provision in the US Model and subsequently in the OECD Model influenced the final decision of the UN Model to adopt it. As a S. 91result, the 2017 UN Model version added the hybrid entity provision in Article 1(2). The UN Model hybrid entity provision replicates the OECD Model wording, which, as stated, is heavily based on the US Model provision. This aspect is noteworthy since both the US Model and the OECD Model tend to favor residence state taxation, as opposed to major emphasis to source state taxation in the UN Model.

As influenced by the US and OECD Models, the UN Model’s hybrid entity clause follows the principle that the source state should follow the income allocation carried out by the residence state. Interestingly, the fact that this circumstance may lead to a loss of tax revenue for source states/developing states did not stop the UN from including such hybrid entity provision in its UN Model, even though the UN Model protects developing countries interests and favors source-state taxation. Schwechel sheds light on a potential reason for the UN to include the residence-state oriented hybrid entity provision, stressing that, should countries not introduce the provision in their tax treaties, the conflicts of allocation of income of hybrid entities may remain unresolved.

The adoption of the hybrid entity provision in tax treaties in a harmonized way represents an important measure to tackle income allocation conflicts when derived by or through a hybrid entity. Consequently, the existence of substantially similar hybrid entity provisions in the US, OECD and UN Models provides for an important degree of harmonization in the international tax system, which facilitates tax treaty negotiation and enhances a higher level of legal certainty. It is reasonable to assume that both the OECD and the UN have considered the importance of harmonization when introducing their hybrid entity provisions in their respective tax models, as influenced by the US Model provision.

5. Final Remarks

Diverging characterization of entities in different jurisdictions leads to hybridity in the international tax sphere. The US check-the-box system (in force since 1996) allows taxpayers the possibility to elect the tax treatment of certain entities for US tax purposes, a situation that may lead to scenarios of double taxation and double non-taxation, based on the hybrid nature of these entities. Based on the above, taxpayers can implement tax planning structures involving the US that take advantage of hybrid situations in order to avoid having any tax (US or foreign) apply to certain items of income.

The US understood this situation from an early stage and included the proper allocation of income derived by a transparent entity as one of its international tax S. 92policy issues. Consequently, the US Model has included the hybrid entity provision since 1996, which has proved to be very influential for international tax matters. In accordance with their tax policy, the US has always tried to ensure that the hybrid entity provision does not prevent the US from taxing its residents and citizens according to its domestic tax law, hence, the saving clause has always been present throughout US tax treaty practice.

Moreover, the main goal of the hybrid entity provision as conceived by the US is to solve conflicts of allocation of income regarding hybrid entities in DTCs. The US hybrid entity provision is based on the principle that for solving said allocation conflicts, the source state should follow the residence state’s treatment, a position shared by the 1999 OECD Partnership Report. The OECD and UN Models eventually adopted a hybrid entity clause heavily based on the US Model provision, leading to a highly harmonized hybrid entity rule.^,

Now, when applying the hybrid entity provision of the US Model to factual scenarios, important issues remain unresolved: i) the source state needs to follow the residence state, and, in doing so, it is exposed to an important decrease of taxing rights (the saving clause preserves important taxing rights of the source state and should be introduced by states on a reciprocal basis when negotiating with the US) ii) the application of the hybrid entity provision of the US Model may be contradictory with Articles 10, 11 and 12 of the US Model, which require the beneficial owner of the income to be a resident of the other state, and iii) the practical application of the double taxation relief method provision may lead to disputes between states.

Although the above-mentioned problems remain unsolved, the hybrid entity provision of the US Model and the high level of harmonization with the OECD and UN Models’ hybrid entity provisions provide for an important measure to address income allocation conflicts regarding hybrid entities that otherwise would remain unsettled.