BEPS (Part 3) — Senator Baucus Targets Hybrids

By Philip D. Morrison, Esq.  

Deloitte Tax LLP, Washington, DC

Some of the recent commentary on the OECD's Base Erosion and
Profit Shifting (BEPS) Action Plan,1 including my own,2 alludes to the
concern that unilateral action to address what is called "double
non-taxation" may inevitably result in the reverse -
actual, unrelieved double taxation. This is particularly true with
hybrid entities, instruments, and transactions if both the payor
country and the recipient country enact provisions to include the
taxable income that previously was untaxed. Presentations I have
attended recently have focused chiefly on proposed or recently
enacted French and Mexican provisions. Now, with the release of
Senator Baucus's international tax reform discussion draft3 (the "Baucus
Proposal"), we can add a U.S. proposal to the mix.

The OECD's BEPS Action Plan's Action 2, entitled Neutralise
the effects of hybrid mismatch arrangements,
 provides as

Develop … recommendations regarding the design of domestic rules
to neutralise the effect (e.g. double non-taxation, double
deduction, long-term deferral) of hybrid instruments and entities.
This may include: … (ii) domestic law provisions that prevent
exemption or non-recognition for payments that are deductible by
the payor; (iii) domestic law provisions that deny a deduction for
a payment that is not includible in income by the recipient (and is

not subject to taxation under controlled foreign company (CFC) or
similar rules); (iv) domestic law provisions that deny a deduction
for a payment that is also deductible in another jurisdiction; and
(v) where necessary, guidance on coordination or tie-breaker rules
if more than one country seeks to apply such rules to a transaction
or structure.

The thorny challenge, of course, is to address item (v) in the
quote above - what to do when countries on both sides of an item
(subject to hybrid treatment) claim the income (e.g., one denies a
deduction, and the other denies an exemption or a second deduction
on the same payment). Not surprisingly, while exemption or
deduction denials for hybrids are beginning to be proposed, there
appears to be virtually no guidance yet devoted to this specific
problem.  More regarding this below.

Though the press release doesn't mention the OECD's BEPS Action
Plan, the Baucus Proposal aggressively addresses the perceived
problem of double non-taxation suggested by Action Item 2,
apparently for the reasons summarized in the Action Plan.
Specifically, the Baucus Proposal would amend the Code to deny a
deduction for any related-party payment "arising in connection with
a base erosion arrangement." "[A]rising in connection with" is

A "base erosion arrangement" is:… any transaction, series of
transactions, or other arrangement which reduces the amount of
foreign income tax paid or accrued and which involves any of the

(A) A hybrid transaction or instrument.

(B) A hybrid entity.

(C) An exemption arrangement.

(D) A conduit financing arrangement.4

A "conduit financing arrangement" is defined in virtually the
same terms as used in Regs. §1.881-3.  An "exemption
arrangement" is defined as:… any provision of any foreign income
tax law which has the effect of reducing the generally applicable
statutory rate on income derived by a person subject to the foreign
income tax by 30 percent or more as applied to a specific item of
income or to income from specified activities.

A "hybrid entity" is any entity that is transparent for one
country's income tax law but not for another's.  A "hybrid
transaction or instrument" is one that the issuer treats as debt
and the holder does not.

The proposed legislative language leaves a great deal to the
imagination. First, how close a connection need there be for a
related-party payment to "arise in connection with" a base erosion
arrangement? Will the standard of Regs. §1.881-3 be used where, for
example, a year's separation between one transaction and another is
a close enough connection? Will the Regs. §1.881-3 rules treating
in some cases a parent and subsidiary as a single intermediate
entity be used here? Second, whose foreign tax must be reduced for
there to be a base erosion arrangement? Is it clear that the
foreign tax reduced must be the tax of a related person? Third, how
broad is the term "exemption arrangement" meant to be? Is a payment
from a U.S. debtor to a third-country branch of a foreign finco
intended to be included? Finally, what happens if the foreign
jurisdiction's reduction of their tax depends on whether or not the
U.S. payor gets a deduction? Which comes first, the U.S. deduction
denial or the foreign exemption denial? Or do both apply-i.e.,
double tax?

While one can hope for a bit more clarity regarding the
proposal's intended scope through refinement of the statutory
language and legislative history, the Joint Committee's Technical
Explanation (TE)5 begins to make clear
how very broadly the proposal is intended to reach. In an example,
the TE makes clear that a hybrid instrument between two foreign
entities can trigger the provision's denial of a U.S. deduction.
The example describes a foreign parent funding a foreign finco
(resident in a country different from that in which its parent is
resident) with a hybrid instrument that is debt for purposes of
finco's country's tax but equity for purposes of parent's country's
tax. Finco then makes a loan to a U.S. subsidiary of foreign
parent. If, as is likely the case, the hybrid between parent and
finco has the result of reducing foreign tax (finco's or parent's
or both), the provision would deny the U.S. subsidiary its interest
deduction. Another example describes a typical "repo" transaction
which, for U.S. tax purposes, has long been considered a secured
financing. Most foreign countries, however, treat the stock that is
sold and subject to repurchase as actually owned by the "buyer" for
the period it holds the stock. The proposal would deny the U.S.
seller/borrower its deemed interest deduction.

An important place where the hybrid proposal is silent is the
question of how the proposal would interact with a foreign
country's law that deals with hybridity by denying an exemption on
the receipt of the income item. Assume, for example, that the
foreign counterparty in a related-party repo is denied a
participation exemption for dividends on the stock it has purchased
and promised to resell, but only if the payor is allowed a
deduction for those payments in its country. Which is applied
first, the deduction denial in the United States or the exemption
denial in the foreign country? Certainly there will be an effort to
make sure that the two provisions do not cancel out each other's
application such that neither applies. But is the opposite an
acceptable answer? Should both the payor's deduction and the
recipient's exemption be denied? Although a government may prefer
an in terrorem effect to prevent the planned use of
hybrids by providing that both can apply, there may be some cases
where a taxpayer mistakenly stumbles into the application of the
proposed provision and would suffer double taxation. That seems
unfair. It is, however, consistent with how some treaties address
the elimination or reduction of withholding tax on
profit-participating debt. So, while it may be unfair, one cannot
claim it is wholly unprecedented. And what happens if all three
countries in the TE's first example have anti-hybrid provisions? Is
triple tax justified?

While most taxpayers will claim that the entire Baucus Proposal
is unlikely to become law, this anti-hybrid proposal may bear
special attention. First, it appears that a relatively narrow
revenue-raiser, which may be described as addressing an "abuse," is
likely to have a life of its own, regardless of the fate of broader
tax reform. Second, and more important, there seems to be a growing
policy consensus among governments that cross-border tax arbitrage
should be stopped. The law and policy up to now, at least outside
the treaty realm, appear to require only that taxpayers get
domestic compliance right. Where treaty benefits are claimed,
admittedly, the other country's treatment of an item ought to
matter because treaty benefits are only granted on the supposition
that one country is ceding tax jurisdiction to another. Outside of
treaty benefits, this has not been the thinking until recently.
Why, if U.S. law clearly provides that an instrument is debt,
should its characterization as equity in a jurisdiction overly
dependent on a transaction's form change the answer? Unfortunately,
that question is one that today many policymakers may not ask.
Given the BEPS Action Plan and a lot of popular press attention
paid to "nowhere" or "stateless" income, careful and complete
compliance with each country's laws might still be characterized as
"abusive" if the result is a deduction in one place and no
inclusion in the other. Accordingly, the eventual enactment of
something like Senator Baucus's anti-hybrid proposal might be
something to expect.

This commentary also will appear in the January 2014 issue
of the
 Tax Management International Journal.
 For more information, in the Tax Management Portfolios,
see Daher, 536 T.M.
, Interest Expense Deductions, Maruca
and Warner, 886 T.M.
, Transfer Pricing: The Code, the
Regulations, and Selected Case Law, Nauheim and Scott, 938
, U.S. Income Tax Treaties - Income Not Attributable to a
Permanent Establishment, and in Tax Practice Series, see ¶2330,
Interest Expense, ¶3600, Section 482 - Allocations of Income and
Deductions Between Related Taxpayers, and ¶7160, U.S. Income Tax



  1 Action Plan on Base Erosion and Profit
 released July 19, 2013, and endorsed by the G20 in July
(Finance Ministerial level) and September (Heads of State

  2 See "BEPS (Part 1) - An `Action
Plan' With Some Internal Contradictions," 42 Tax Mgmt. Int'l
557 (9/13/13), and "BEPS (Part 2) - A Multilateral Tax
Treaty?" 42 Tax Mgmt. Int'l J. 626 (10/11/13).

  3 International Business Tax Reform Discussion
, Staff of the U.S. Senate Finance Committee, Nov. 19,

  4 Baucus Proposal re provisions common to
options Y and Z, at p. 60.

  5 Technical Explanation of the Senate Committee
on Finance Chairman's Staff Discussion Draft of Provisions to
Reform International Business Taxation
, Staff of the Joint
Committee on Taxation, JCX-15-13 (11/19/13).