In Chief Counsel Advice AM 2025-002 (dated Sept. 8, 2025; released Sept. 19, 2025) (Memorandum), the IRS analyzed how U.S. income tax treaties apply to the branch profits tax (BPT) under Section 884 when business profits are earned through a reverse foreign hybrid, i.e., a foreign entity treated as a corporation for U.S. tax purposes but fiscally transparent under the owners’ residence-country laws.
1. Background Facts
The Memorandum considered a Country X entity (RFHX) that is fiscally transparent in Countries X, Y, and Z, but a corporation for U.S. tax purposes. RFHX is owned equally by four investors with differing profiles and treaty eligibility. Owner A is an individual resident of Country Y; owner B is a publicly traded Country Y corporation whose shares have been regularly and primarily traded for more than 12 months; owner C is a privately held Country Y corporation wholly owned by individual residents of Country Z; and owner D is an individual resident of Country Z.
RFHX conducts a U.S. trade or business, generating income that is effectively connected with that trade or business (ECI). For U.S. tax purposes, it pays corporate income tax at the 21% rate under Sections 11 and 882. In addition, and absent treaty relief, RFHX is subject to the 30% BPT Section 884 imposes on its dividend equivalent amount (DEA), generally defined as its effectively connected earnings and profits (E&P) for the year, adjusted for increases or decreases in U.S. net equity. Because RFHX distributes all of its income currently to its owners and retains no earnings, its DEA equals its ECI.
The United States maintains an income tax treaty with Country Y, modeled on the 2016 U.S. Model Income Tax Convention, but has no treaties with Country X or Country Z. The U.S.–Country Y treaty contains a fiscally transparent entity (FTE) rule, a branch profits tax (BPT) article, and a limitation on benefits (LOB) clause, all of which are central to the analysis in the memorandum.
2. Prior Uncertainty on Treaty Relief for Reverse Hybrids
Prior to the issuance of AM 2025-002, there was limited guidance on how U.S. income tax treaties applied to reverse hybrid entities in the context of the BPT. The uncertainty centered on several interrelated issues. First, there was ambiguity over who qualified as the “resident” entitled to treaty benefits. Because a reverse hybrid is not liable to tax in its home country, it generally does not meet the treaty definition of a resident, raising the question of whether treaty benefits may nevertheless flow through to its owners under the FTE rule. Second, taxpayers and practitioners lacked clarity on how the FTE rule interacts with Section 884, which imposes the BPT on a “foreign corporation.” It was unclear whether the FTE rule could override Section 884 to eliminate or reduce the BPT if the underlying owners were treaty residents. Third, there was uncertainty regarding the appropriate level for limitation on benefits (LOB) testing, whether it should apply to the entity itself or instead to the owners of the reverse hybrid. Finally, no prior IRS or Treasury guidance had addressed whether a fiscally transparent owner’s share of the dividend equivalent amount (DEA) could qualify for a reduced treaty rate on a proportional, owner-by-owner basis.
AM 2025-002 fills these gaps by providing the first comprehensive interpretation of how U.S. tax treaties interact with the Section 884 branch profits tax in the reverse hybrid context, offering guidance for structures where treaty-resident investors participate through entities treated as corporations for U.S. purposes but transparent under foreign law.
3. Branch Profits Tax: General Applicable Rules
The Section 884 BPT serves as a mechanism to replicate the second-level dividend withholding tax that would apply if a foreign corporation conducted its U.S. operations through a subsidiary rather than directly through a branch. In substance, the BPT seeks to ensure parity between a foreign corporation’s U.S. branch and a U.S. subsidiary owned by a foreign parent, preventing the foreign corporation from avoiding dividend withholding tax by simply repatriating branch profits without a formal distribution.
The tax base for the BPT is the DEA, which functions as a proxy for the profits deemed repatriated from the United States. The DEA represents the foreign corporation’s effectively connected E&P for the taxable year, adjusted to reflect changes in U.S. net equity. Specifically, increases in U.S. net equity, such as capital infusions or reinvestments of earnings into U.S. assets, reduce the DEA, as they indicate profit retention in the United States. Conversely, decreases in U.S. net equity, such as withdrawals or repatriations of funds to the foreign parent, increase the DEA, signaling a deemed distribution subject to the BPT.
The BPT is imposed at a statutory rate of 30%, although treaty provisions may reduce this rate for qualifying residents of treaty jurisdictions, aligning it with the treaty’s maximum withholding rate on dividends. The policy objective underlying Section 884 is to ensure neutral treatment between U.S. branches and subsidiaries of foreign corporations, thereby preventing the erosion of the U.S. tax base through branch structures that facilitate untaxed profit remittances abroad.
4. IRS Findings: Owner-by-Owner Treaty Relief for BPT; Entity Remains the U.S. Taxpayer
The IRS concluded that RFHX, classified as a corporation for U.S. purposes, remains the taxpayer for corporate income tax and BPT purposes. The memorandum makes it clear that the FTE rule contained in the U.S.–Country Y income tax treaty does not displace or override the statutory framework of Section 884. Rather, while the treaty may modify the applicable tax rate, it does so only with respect to the portions of RFHX’s DEA that are allocable to owners who qualify for treaty benefits under the FTE and LOB provisions. The structure and mechanics of Section 884, including the taxpayer determination, the DEA computation, and the imposition of the BPT at the corporate level, does not change.
Specifically, under the FTE rule in the U.S.–Country Y treaty, business profits derived through a fiscally transparent entity are treated as derived by the resident owners of that entity, but only to the extent that those profits are taxed to the owners under the laws of their country of residence. Applying this rule, the IRS recognized that each Country Y owner of RFHX who is taxed on its distributive share of RFHX’s income under Country Y law is deemed to derive that income for treaty purposes. For the BPT, however, the term “company” is determined solely under U.S. law. Because RFHX is treated as a corporation for U.S. tax purposes and operates through a U.S. permanent establishment, it remains directly subject to Section 884.
Based on the above, the IRS clarified that treaty-based rate reductions apply proportionally, on an owner-by-owner basis, provided that as of year-end: (i) the owner is a resident of Country Y; (ii) the owner is taxed on its share under Country Y law; and (iii) the owner meets the LOB requirements, including any ownership and base erosion tests. The memorandum further noted that the 12-month residency requirement contained in the BPT article must also be satisfied at the owner level and measured through the close of the reverse hybrid’s taxable year, which is the point at which entitlement to the DEA is fixed under Section 884. This timing rule ensures that only those owners who have maintained treaty residency throughout the relevant period may benefit from a reduced BPT rate.
Applying these standards, the IRS found that Owners A and B, both Country Y residents meeting the LOB and taxation requirements, qualified for reduced BPT rates under the treaty, while Owner C, a Country Y corporation failing the LOB test, and Owner D, a non-treaty resident of Country Z, did not qualify for the reduced rate. Their respective allocable portions of the DEA therefore remained subject to the full 30% statutory rate, regardless of whether any investor not eligible for the treaty benefits is an individual to which BPT otherwise does not apply.
5. Tax Implications and Impact of AM 2025-002 for Reverse Hybrids and Treaty Application
This guidance confirms that treaty relief from BPT is available for reverse hybrids, but only on an owner-by-owner basis. The entity’s corporate-level tax and the structural application of Section 884 (DEA mechanics and “company” status) remain unchanged. Critically, the FTE rule reaches business profits, not merely fixed, determinable, annual, or periodical (FDAP) items, so look-through may make treaty residency, taxation, and LOB relevant for each owner. But because BPT is a second-level tax on a corporate taxpayer, the treaty does not recast the tax base as if individuals or non-corporate owners were the taxpayers. Instead, it modifies the rate on the DEA portion attributable to each qualifying owner.
The memorandum also clarifies a timing issue, i.e., the 12-month residency requirement in the BPT article is tested at the owner level and measured through the close of the reverse hybrid’s taxable year (i.e., the moment entitlement to the DEA is fixed under Section 884). This timing rule may have practical consequences for year-end ownership changes.
The memorandum’s conclusions have broad implications across a spectrum of cross-border investment structures, particularly those involving mixed treaty and non-treaty ownership. The guidance directly affects:
- Private funds and investment platforms that use reverse hybrids to hold U.S. assets;
- Multinational finance and credit vehicles operating through U.S. branches; and
- Joint ventures that include both treaty-resident and non-treaty investors.
In such cases, the entity may be subject to blended BPT rates, reflecting a combination of reduced treaty rates for qualifying owners and the statutory 30% rate for others. Specifically:
- Publicly traded and individual treaty residents typically meet LOB requirements more easily and may access reduced BPT rates.
- Privately held entities must substantiate compliance with both the qualified ownership and base erosion tests to claim treaty relief.
- Non-treaty or non-qualifying owners remain fully exposed to the 30% statutory rate on their allocable share of the DEA, regardless of whether such owners are individuals.
- Maintain owner-level treaty eligibility.
- Monitor the 12-month clock.
- Optimize the DEA.
- Consider segregating qualifying and non-qualifying investors.
- Match treaty claims with documentation and returns.
- Treaty text drives outcomes.
6. Practical Considerations for Taxpayers
Because BPT relief is computed slice-by-slice, companies may wish to map each owner’s residency, FTE taxation status, and LOB at least quarterly and as of year-end. Private companies should consider documenting qualified ownership and base-erosion compliance over the required testing period.
The treaty’s BPT article typically requires continuous residency in the relevant treaty jurisdiction for the 12-month period ending on the entity’s year-end. Late-year transfers or redomiciliations might forfeit reduced rates for an otherwise qualifying slice.
DEA broadly tracks effectively connected E&P adjusted for U.S. net equity. Capitalizing the U.S. branch or retaining earnings may increase U.S. net equity (USNE) and reduce DEA, while withdrawals may increase DEA. Companies might consider modeling USNE movements together with owner-by-owner treaty rates to identify the lowest blended BPT outcome.
Separate reverse-hybrid vehicles (or branches) for treaty-qualified vs. non-qualified owners may ring-fence the 30% BPT component and simplify compliance/documentation. Ensure that any restructuring is consistent with LOB (including anti-conduit rules) and commercial substance.
Align owner certifications (residency certificates, LOB support, and evidence that items are taxed to the owner in the residence country) with Form 1120-F positions and BPT computations. Maintain a robust treaty file and, where applicable, Form 8833 disclosure. Keep calculations demonstrating the owner-by-owner allocation of the DEA and corresponding rates.
The analysis in this Memorandum assumes a treaty consistent with the 2016 U.S. Model (FTE/BPT/LOB). Actual treaties vary (e.g., wording of the BPT article, presence of derivative benefits, active trade or business tests, stock-exchange definitions, or base-erosion thresholds). Taxpayers must confirm specific treaty language and technical explanations.
7. Conclusion
AM 2025-002 is a clarifying development for reverse hybrids exposed to Section 884, confirming that treaty-based BPT reductions are available on a proportional, owner-by-owner basis where owners are (i) treaty residents, (ii) taxed on their shares under residence-country law due to transparency, and (iii) satisfy LOB. The Memorandum clarifies that the reverse hybrid remains the U.S. corporate taxpayer for ECI and BPT and the treaty modifies the rate, not the tax base.
The ruling is particularly relevant for multinational investment platforms, private funds, and other structures involving foreign entities classified as corporations for U.S. purposes but transparent under foreign law. These taxpayers should implement robust documentation and monitoring systems to substantiate treaty eligibility, manage ownership changes, and optimize U.S. net equity for BPT efficiency.
Although non-precedential, AM 2025-002 provides valuable insight into the IRS’s current interpretation of Section 884, considering modern treaty provisions. Taxpayers should continue to monitor future developments and confirm treaty language before relying on similar positions.