In a welcome development, the IRS Office of the Chief Counsel addressed, in a generic legal advice memorandum (AM 2025-002 or GLAM, released September 19, 2025), the application of a US income tax treaty to reduce the BPT applicable to a "reverse foreign hybrid" (i.e., a foreign entity treated as a corporation for US tax purposes but as fiscally transparent under the laws of its country of organization and its owners' countries). The IRS concluded that the reverse foreign hybrid may qualify for a reduced rate of BPT on the portion of the DEA corresponding to interests held by the owners who are resident in a treaty country and meet certain treaty eligibility requirements.

This discussion on the treatment of reverse foreign hybrids under US treaties is significant and provides guidance in an area that has long been the subject of debate.¹ The GLAM provides welcome confirmation that treaty benefits may be available in these cross-border structures, offering taxpayers a clearer framework for evaluating BPT exposure in foreign reverse hybrid scenarios.

Background

BPT provisions

Generally, a foreign corporation that is engaged in a trade or business in the US during a tax year is subject to US federal income tax on its effectively connected income (ECI) under IRC Section 882(a). In addition, IRC Section 884 imposes a 30% BPT on the corporation's DEA.

The term DEA for any tax year means the foreign corporation's effectively connected E&P for the tax year (i) reduced for an increase in US net equity (but not below zero), and (ii) increased for a decrease in US net equity. US net equity is generally the excess of the basis of assets connected with the US trade or business over liabilities so connected. An increase in US net equity represents a reinvestment of US earnings in a US trade or business and a decrease in US net equity represents a divestment of US earnings accumulated in prior years.

IRC Section 884(e)(2) allows foreign corporations that are qualified residents of a treaty partner country to be subject to reduced BPT rates. US tax treaties entered into or amended after the enactment of the BPT generally address the BPT. Most of these treaties reduce or eliminate the BPT rate to the same extent that tax rates on dividends are reduced or eliminated under the treaty.

The GLAM assumes that the treaty at issue is worded consistently with the 2016 United States Model Income Tax Convention (2016 Model) and applies the provisions of the 2016 Model to determine the treatment of the BPT.

Under Article 7(1) of the 2016 Model, the business profits of an enterprise of a resident of one country are taxable in the other country only if the enterprise carries on the business through a permanent establishment (PE) to which the profits are attributable. Under Article 10(10), the profit portion that is attributable to the PE and represents the DEA may be subject to an additional tax (in this case, the BPT); the tax, however, would apply at a reduced rate if the company has been a resident of the relevant country for the 12-month period ending on the date on which the entitlement to the DEA is determined (BPT provision).

FTE provisions

The 2016 Model's FTE provision addresses how treaty benefits apply to income earned by or through entities that are fiscally transparent under the laws of either Contracting State. Specifically, it considers an "item of income, profit or gain derived by or through an entity that is treated as wholly or partly fiscally transparent" to be derived by a resident of a Contracting State only to the extent that the item is treated, under that State's tax law, as the income, profit or gain of a resident of that State.

The regulations under IRC Section 894 also address income derived through fiscally transparent entities, but their application is expressly limited to certain items of income, such as fixed or determinable annual or periodical income (FDAP income) subject to IRC Sections 871(a) and 881(a). Specifically, Treas. Reg. Section 1.894-1(d) considers an item of FDAP income paid to an entity to be derived by an interest holder in a fiscally transparent entity if (i) the entity is fiscally transparent in the interest holder's jurisdiction, and (ii) the interest holder is not fiscally transparent with respect to that item of income in its jurisdiction.

Fact pattern

The following section outlines key facts relevant to the analysis described in the GLAM:

• RFHX is an entity in Country X, which is treated as a corporation for US tax purposes and fiscally transparent in Countries X, Y, and Z.
• RFHX is equally owned by — (i) A, an individual resident in country Y; (ii) B, a corporation that is a tax resident in Country Y; (iii) C, a privately held corporation that is a tax resident in Country Y and whose shares are owned by individuals resident in Country Z; and (iv) D, an individual resident in Country Z.
• The US has an income tax treaty with Country Y identical to the 2016 Model. The US does not have an income tax treaty with County X or Country Z.
• RFHX's income is ECI. Similarly, RFHX's income is business profits attributable to a US PE under the US-Country Y tax treaty.
• In these facts, RFHX is subject to corporate income tax (i.e., 21%) under IRC Section 882 on its income that is both ECI and business profits attributable to its US PE. Unless modified by a treaty, RFHX would also be subject to a 30% BPT on its DEA.
• Individual A and corporation B satisfy the LOB provision under the US-Country Y treaty. Corporation C does not satisfy the LOB provision under the US-Country Y treaty (e.g., the GLAM assumes that Corporation C would not satisfy the active-trade-or-business test).

IRS conclusions

Scope of the FTE provision

The GLAM confirms that the FTE provision in the 2016 Model applies broadly to all types of income, including business profits earned by or through a fiscally transparent entity. The GLAM contrasts the scope of the FTE provision against the narrower scope of Treas. Reg. Section 1.894-1(d), which applies only to items of FDAP income. Those regulations, the GLAM notes, were adopted when many US income tax treaties did not include an FTE provision with wording like the current Model's and were intended to apply their principles to US treaties generally. Nevertheless, the GLAM states, the FTE provision in most current treaties applies to any item of income, profit or gain, not just FDAP income.

Business profits derived through a reverse foreign hybrid

As a fiscally transparent entity in the state in which it is organized (i.e., Country X), RFHX is not considered to be a resident of that country. The GLAM concludes, however, that its owners, who are residents in Country Y, are considered to derive their share of business profits under the FTE provision of the US-Country Y tax treaty, to the extent that those business profits are treated in Country Y as income of a resident.

For purposes of determining eligibility for treaty benefits, the GLAM concludes that the LOB requirements must be applied at the level of RFHX's owners. Under the facts presented in the GLAM, only A and B are owners that are residents of Country Y and satisfy the LOB requirements. Therefore, treaty benefits are available only on the portion of the DEA corresponding to A's and B's interest in RFHX.

While noting the FTE provision could be interpreted to consider the FTE as the resident under the treaty to the extent that the income of the FTE is subject to tax in the hands of its owners, the GLAM does not adopt this approach. The GLAM goes on to state that the treaty, however, does not change the person treated as the "taxpayer" under the laws of the country imposing its tax (which in this case, would be the US); consequently, RFHX, which is treated as a corporation for US tax purposes, is considered subject to BPT. To maintain the US's right to treat the FTE as the taxpayer, the GLAM explains, the FTE's US tax classification must be taken into account when determining its BPT liability corresponding to the interest of a treaty-qualified owner, even if that owner is not itself a company (see discussion later).

Interaction of the FTE and BPT provisions

Under IRC Section 884, BPT is a second-level tax on a corporation. Similarly, under a tax treaty, the BPT provision generally allows a Contracting State to impose a BPT on the portion of business profits comprising a DEA of a "company." The 2016 Model defines a company as "any body corporate or any entity that is treated as a body corporate for tax purposes" under the laws of the residence State "unless the context otherwise requires."

According to the GLAM, the context of a DEA arising from profits derived through an FTE requires departure from this treaty-defined term. Specifically, to give effect to the object and purpose of the BPT provision (i.e., that BPT is a second-level tax on a corporation), the term "company" must be interpreted by referencing the classification of the entity in the source State. As a result, applying the FTE and BPT provisions together, the GLAM concludes that (1) each country Y resident owner is treated as deriving their share of business profits earned by RFHX; (2) the profits earned by RFHX are attributable to a US PE and RFHX is subject to 21% corporate income tax on those profits; and (3) each Country Y resident owner is also treated as deriving a DEA comprising profits that are characterized as profits of a company attributable to a PE. Accordingly, the GLAM rejects arguments that the reverse foreign hybrid's business profits allocable to individuals are to be taxed at individual rates (instead of the corporate 21% rate) or that no BPT applies on the reverse foreign hybrid's DEA corresponding to the interests held by individuals.

The GLAM clarifies that this modified approach to the application of the FTE provision, which considers the FTE's tax attributes and characteristics under US law, is limited to the BPT. The modified approach is not needed for FDAP income derived through an FTE because (i) the entity's tax attributes and characteristics under US law are not relevant in that case, and (ii) the context does not require a departure from the treaty-defined term "company." For example, the GLAM notes, looking to the law of the residence State to determine whether the resident owner is regarded as a "company" under the treaty is appropriate when determining whether a treaty resident is entitled to a reduced rate of tax under Article 10(2)(a) of the 2016 Model on dividend income (not representing business profits) derived through an FTE.

Twelve-month residency requirement

The GLAM concludes that the owner of the reverse foreign hybrid must satisfy the BPT provision's 12-month residency requirement since the determination of whether income is the income of a resident is made at the owner level. Moreover, the residency requirement must be satisfied by the close of the reverse foreign hybrid's tax year, as that is the first date on which all facts needed to determine the DEA exist.²

Conclusion under the 2016 Model

The GLAM concludes that RFHX is subject to the 21% corporate income tax rate on its business profits and, additionally, to the BPT. However, it may claim a reduced BPT rate on the portion of its DEA corresponding to the interests held by A and B — treaty qualified residents of Country Y. On the portion of its DEA corresponding to the interests held by C and D, RFHX must pay a 30% BPT rate since C and D are not treaty qualified residents of Country Y. RFHX remains the taxpayer under US law and must report its business profits and BPT and pay the tax due.

Conclusion under other Model Treaties

The GLAM notes that similar conclusions would apply under treaties with the FTE provisions from the 2006 and 1996 Models, even though those prior US model treaties contain slightly different language as they refer to income derived "through an entity that is fiscally transparent" rather than "by or through an entity that is treated as wholly or partly transparent." According to the GLAM, this is not a substantive difference, and the 2016 Model language is merely intended to reflect differences in how Contracting States view who derives the income (e.g., the entity, or the owners of the entity). The conclusions would also be similar under treaties containing the language of the draft 1981 US Model Income and Capital Tax Convention.

Implications

The GLAM is a welcome development for taxpayers, confirming that treaties may apply to reduce the rate of BPT for treaty-qualified owners of entities that are treated as fiscally transparent for foreign tax purposes but treated as corporations for US tax purposes. By referencing prior US model treaties, the GLAM also offers helpful guidance for taxpayers under older treaty frameworks.

Importantly, the GLAM clarifies that the corporate classification of a reverse foreign hybrid under US law must be respected for purposes of applying a treaty's BPT provision. As a result, business profits allocable to individual owners of a reverse foreign hybrid are subject to the corporate tax rate of 21%, rather than individual rates, and the BPT applies to the DEA corresponding to the interests of individual owners as well as owners that are entities.

Although the GLAM's BPT analysis focuses on reverse foreign hybrids deriving ECI from a US trade or business, it also notes that similar analysis applies to income treated as ECI from the operation of US real property or the disposition of US real property interests described in IRC Section 897(c)(1)(A).

The GLAM references the fact that RFHX had complied with its US tax obligations, including its corporate income tax and BPT obligations, and met any applicable documentation requirements associated with claiming a reduced rate of BPT on its DEA. The GLAM does not provide details of the applicable documentation, but the reverse foreign hybrid would presumably be required to file Form 1120-F, US Income Tax Return of a Foreign Corporation, as well as Form 8833, Treaty Based Return Position, which references the treaty-qualified owners that are claiming the reduced rate of BPT in relation to their share of the DEA. The reverse foreign hybrid would presumably also have obtained relevant Forms W-8 from its investors substantiating their eligibility for treaty benefits.

While non-precedential, the GLAM provides valuable insight into the IRS's interpretation of treaty provisions in the context of reverse foreign hybrids and BPT. Taxpayers should monitor further developments, as the GLAM indicates that additional guidance may be forthcoming and its conclusions may be superseded.