Neutralizing Hybrid Mismatch Arrangements: BEPS Action 2


Action 2 of BEPS deals with hybrid mismatch arrangements. These are arrangements that achieve a double non-taxation outcome by exploiting differences in the way that jurisdictions treat certain entities or instruments for tax purposes.

Some might view such arrangements as fine examples of the corporate tax planner’s art. To the OECD, however, they are among the most egregious instances of base erosion and profit shifting. In its final report on Action 2, the OECD provides recommendations for neutralizing their effect.

Hybrid Mismatch Outcomes

Running to 454 pages, including 285 pages of examples, the Action 2 report divides hybrid mismatch arrangements into three broad categories, based on the tax outcome generated rather than the nature of the hybrid arrangement itself. These categories are as follows:

  • deduction/no inclusion (D/NI) outcome;
  • double deduction (DD) outcome; and
  • imported mismatch or indirect D/NI outcome.

We’ll look at each of them in turn.

(i) D/NI Outcome

This involves a payment that generates a deduction for the payer, but isn’t included in the payee’s taxable income. The Action 2 report provides numerous examples of this and the other mismatch outcomes. There’s no space here to review those examples, but a simple example of the D/NI outcome would be as follows:

  • country X allows a deduction for interest payments;
  • country Y grants an exemption for dividends paid by subsidiaries to parents (i.e., a participation exemption);
  • a country X subsidiary makes a payment to its country Y parent under a hybrid instrument;
  • country X treats the payment as interest, and so allows the subsidiary to deduct it from taxable income;
  • country Y treats the payment as a dividend, and so doesn’t tax it in the hands of the parent.

To counter this double non-taxation outcome, the Action 2 report recommends that the jurisdiction of the payer should deny the deduction. This is the primary rule. If the deduction isn’t denied, then the jurisdiction of the payee should tax the payment as ordinary income. The report refers to this fall-back position as “the defensive rule”.

(ii) DD Outcome

This category covers hybrid mismatch arrangements that generate more than one deduction in respect of a single payment. A very simple example would be as follows:

  • an entity resident in country X has corporate investors resident in country Y;
  • country X treats the entity as opaque for tax purposes, but country Y treats it as transparent;
  • the country X entity makes a tax-deductible payment to a third party;
  • country X regards the expense as having been incurred by the payer entity, and therefore allows it to deduct the payment;
  • country Y regards the cost as flowing through to the corporate investors, and so allows them a deduction in respect of same payment.

In this instance, the Action 2 report puts the onus on the investors’ jurisdiction to neutralize the effect of the arrangement. The primary rule therefore requires that jurisdiction to deny the deduction. If it doesn’t do so, then the defensive rule requires the payer entity’s jurisdiction to deny the deduction.

(iii) Imported Mismatch or Indirect D/NI Outcome

This category deals with an arrangement that generates a deduction in a jurisdiction by shifting the effect of an offshore hybrid mismatch to that jurisdiction through a non-hybrid instrument. An ultra-simple example would be as follows:

  • a company resident in country X is the parent of subsidiaries resident in countries Y and Z respectively;
  • country Z has anti-hybrid rules, but countries X and Y don’t;
  • the country X parent provides financing for the country Y subsidiary through a hybrid instrument;
  • a payment made by the country Y subsidiary to the country X parent under the instrument generates a D/NI outcome;
  • as part of the same group financing arrangement, the country Y subsidiary passes on the funding from the country X parent to the country Z subsidiary through a non-hybrid instrument, e.g., an ordinary loan;
  • the country Z company is allowed a deduction on interest payments made by it to the country Y company under the non-hybrid instrument.

In these circumstances, the Action 2 report says that the deduction should be denied by the jurisdiction into which the effect of the offshore hybrid mismatch arrangement has been imported.

Jurisdictional Responses to the Action 2 Report

The Action 2 report has not invented the concept of anti-hybrid rules. Some countries have had such rules in place for several years, e.g., Italy since 2004, the U.K. since 2005 and Denmark since 2007. Other jurisdictions introduced anti-hybrid rules during, but essentially independently of, the BEPS project, e.g., France in 2014; the EU as a whole in the same year through an amendment to its Parent-Subsidiary Directive (denying the EU-wide participation exemption where a dividend payment generates a deduction); and Japan in 2015 (again, the denial of a participation exemption where a dividend payment generates a deduction for the payer). The Action 2 report seeks to replace these ad hoc initiatives with a coherent and uniform set of anti-hybrid rules.

The legislative response to the Action 2 report, though fairly limited so far, now seems to be speeding up. The lead has come from the U.K. which is currently enacting legislation, in its 2016 Finance Bill, to implement the Action 2 recommendations in place of its existing rules from January 1, 2017.

Not for the first time in BEPS-related matters, the U.K.’s lead has been followed by Australia whose May budget contained proposals for legislation to implement the Action 2 report recommendations with effect from 2018.

Nor has the EU been inactive. Its anti-tax avoidance directive (ATAD), approved on June 21 and to be implemented by Member States by December 31, 2018, includes provisions against hybrid mismatches. However, much of the detail has still to be worked out. As they currently stand, the anti-hybrid measures run to only a single page (including the preamble) and say nothing at all about imported mismatches. Contrast this with the U.K.’s pending legislation, described by one practitioner as “not for the faint-hearted”, which runs to 68 pages and is closely based on the 454-page Action 2 report.

When ATAD first came up for approval by EU Finance Ministers at a meeting on May 25, both the U.K. and Ireland pointed to the mismatch between the ATAD proposals and the Action 2 report. More detail, they said, was required, and the rules had to extend to mismatches between Member States and non-Member States. These calls, together with numerous objections to other aspects of ATAD, resulted in a decision on its adoption being deferred until a further meeting of Finance Ministers on June 17.

The document that was finally approved on June 21 contains the original anti-hybrid proposals, but they are now accompanied by a request for the EU’s executive, the Commission, “to put forward a proposal by October 2016 on hybrid mismatches involving third countries in order to provide for rules consistent with and no less effective than the rules recommended by the OECD BEPS report on Action 2, with a view to reaching agreement by the end of 2016”. It is possible that those more detailed rules will be based on the U.K.’s pending legislation. Given the vote by the British people, just two days after ATAD was approved, to leave the EU, this may be the last time that the U.K. influences law-making in the EU.

By Dr Craig Rose, Technical Editor, Global Tax Guide

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