Tax insight

Branch profits tax imposed on foreign reverse hybrid may be reduced or eliminated under tax treaty

Insight
5 minute read
November 20, 2025

What happened?

The IRS on September 19 issued Advice Memorandum (AM) 2025-002, which addresses the extent to which relief is available under a bilaterial income tax treaty from the branch profits tax (BPT) imposed under Section 884 in respect of business profits earned by a foreign entity that is fiscally transparent for foreign tax purposes but treated as a corporation for US tax purposes. The IRS concluded that a reverse hybrid entity with effectively connected income (ECI) may be able to use the owners’ bilateral income tax treaty to reduce its BPT.

Why is it relevant?

Regarding the treaty reduction in the BPT, it is common for an investment fund that anticipates having income that may be subject to US net income taxation to use as an investment vehicle a limited partnership formed in a foreign jurisdiction, such as the Cayman Islands, and then have the investment vehicle elect to be treated as a corporation for US tax purposes in order to shelter its foreign partners from being directly subject to US income taxation and related tax filing requirements. However, when this “foreign reverse hybrid” generates income that is subject to the BPT, and the foreign investor is entitled to the benefits of a treaty providing for the reduction to (or exemption from) the BPT, a long-standing issue arises as to whether the BPT imposed on the foreign reverse hybrid can be reduced or eliminated under the tax treaty between the United States and the owner’s country of residence.

AM 2025-002 addresses this issue and endorses the conclusion that the BPT imposed on the reverse hybrid can be reduced to the extent the underlying profits are considered attributable to a treaty-qualified owner under fiscal transparency principles. The AM applies this favorable conclusion, even where the owner is an individual, although the BPT is applied only to corporations.

Action to consider 

Although the advice in the AM represents a final determination of the position of the IRS only with respect to the specific issue in the specific case in which the AM is issued, investment managers that have or are considering a foreign reverse hybrid structure but were hesitant to apply the treaty reduction might want to consider whether to apply the principles of the AM. The endorsement of this favorable reading could factor into how a fund manager structures its investment fund.