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By James J. Tobin, Esq.1
Ernst & Young LLP, New York, NY
I've finally worked my way through the final OECD BEPS reports released in early October. Very interesting reading and an added bonus was the good cardio exercise of carrying around the 1500 pages for several weeks while finding travel time to slog through them all. Lots of interesting stuff in each of the reports. The overall scope and sheer ambition of the OECD is impressive but, as I've observed before, I think the OECD was too ambitious and that by trying to achieve too much the ultimate achievement will be less than it could have been. But maybe that's a good thing.
The focus of this commentary is on the final report on Action 2 – Neutralising the Effects of Hybrid Mismatch Arrangements. This is an incredibly complex area. I expressed my skepticism about the likelihood of producing workable rules in this area in a prior commentary where I observed, "Given the multitude of reasons why there could be a potential mismatch resulting in a tax benefit to the `borrower' that is greater than the tax cost to the `lender,' it is hard to see the best way to construct an anti-avoidance principle to limit such result… ."2 I still stand by that view, but what I hadn't realized at that time was the appetite for complexity on the part of the OECD in facing the challenge of dealing with the multitude of possible or perceived mismatch situations.
So the comprehensive report on hybrids bravely attempts to deal with all manner of potential mismatches that one could imagine – even a few I had not imagined. The report exceeds 450 pages (single-spaced and dense). It contains 80 examples of particular hybrids and how they should be dealt with, which make up 285 of the 450+ pages. It includes 12 areas of recommendation, all of which are multi-faceted. The recommendations for the most part require legislative action by each country and the intent is that countries all follow a consistent design to ensure achievement of the goal of eliminating the targeted hybrid mismatches. I view the odds of consistent adoption of the numbingly complex recommendations to be near zero, but the chances of selective adoption of any attractive revenue-generating aspects of the report to be high. With the result being greater likelihood of companies facing disallowances, controversy, and double tax.
Recommendation 9 includes the design principles for the report. (I might have thought design principles would come earlier than ninth?) To quote:
The hybrid mismatch rules have been designed to maximize the following outcomes:
(a) Neutralise the mismatch rather than reverse the tax benefit that arises under the laws of the jurisdiction;
(b) Be comprehensive;
(c) Apply automatically;
(d) Avoid double taxation through rule coordination;
(e) Minimize the disruption to existing domestic law;
(f) Be clear and transparent in their operation;
(g) Provide sufficient flexibility for the rule to be incorporated into the laws of each jurisdiction;
(h) Be workable for taxpayers and keep compliance costs to a minimum; and
(i) Minimize the administrative burden on tax authorities; plus
(j) Cure all disease, end poverty, and eradicate world hunger.
Okay, I added on the last one. But even if well-intentioned, the goals are perhaps a bit too lofty and unrealistic to be achievable. I think that's largely borne out when one considers the details. I'll make some comments on the recommendations I find most interesting, which include those on hybrid financial instruments (recommendations 1 and 2), disregarded hybrid payments (recommendation 3), reverse hybrids (recommendations 4 and 5), dual resident payers (recommendation 7), and imported mismatches (recommendation 8).
Starting with hybrid financial instruments – although more complex in its definition, think of a related-party instrument treated as debt in the borrower country but equity in the lender country and the lender country providing beneficial treatment to the dividend recipient in the form of exemption or potentially underlying foreign tax credit relief. The report considers this a deduction/no inclusion (DNI) result (despite the fact that it may really be a deduction combined with an inclusion with credit or a partial rather than full exemption). The report provides for a primary and a secondary response for dealing with this DNI outcome (as had the interim report for Action 2). The primary rule proposed in recommendation 1 is that the payer jurisdiction should deny a tax deduction for what it sees as an interest payment to the extent of the DNI outcome. If the payer jurisdiction does not act to deny the deduction, the secondary rule is for the payee jurisdiction to fully include the payment in income – without underlying credit benefit. Interestingly, recommendation 2, which contains a broad rule for adoption in a country's domestic law, calls for a denial of dividend exemption or a denial of the granting of underlying foreign tax credits for dividends that are deductible in the payer country. This rule would obviously result in the secondary rule becoming the rule and the payer country no longer having a basis to deny a deduction – which seems excessively confusing. So if I try to follow the OECD's path, it's a three-step analysis: First, all countries should act to deny exemption or credit relief for a hybrid dividend. Second, if such a general rule is not adopted by a particular payee country or if it is not applicable to a particular instrument, the payer country of a hybrid mismatch payment should deny the deduction. Third, if there is no such denial by the payer country, the payee country of that hybrid mismatch should fully tax the payment, which would mean denying exemption or credit relief for the payment. Sounds like a bit of a circle, doesn't it?
The recommendations specify that the denial of deduction should be aligned with the extent of the non-taxation of the payee. So if, say, a 90% exemption, then a 90% disallowance. And in situations where the benefit is in the form of a foreign tax credit, there would be a need to compute the extent to which the credit led to a non-tax result. This latter situation seems particularly messy since a disallowance by the payer country would increase the underlying tax on the payer. This would potentially result in a circular calculation. Moreover, the deemed paid credits used to offset the hybrid payment would almost certainly result in there being fewer credits left to offset the payee country tax on future dividends. Thus, a disallowance likely would result in current or eventual double taxation. The report in example 1.4 glosses over this issue. Apparently, potential double tax doesn't merit the same in-depth thinking as does double non-tax.
Differences in timing of deductions versus inclusions are also covered in recommendation 1. This could have an impact on discount notes or similar instruments. The recommendation excludes a timing difference from being considered a hybrid mismatch where the payment will be included as ordinary income "within a reasonable period of time." The report specifies a safe harbor of 12 months as reasonable. Not really long enough to be very comforting when faced with the prospect of a permanent disallowance – again, a double tax risk that is not addressed. To the extent this approach is implemented by countries, there could be some practical issues for multinationals.
Recommendation 3 deals with disregarded payments made by a disregarded entity. So a fact pattern which could exist would be a U.S. multinational (P) that owns a first-tier foreign subsidiary (S1) that is checked as disregarded and that owns a second-tier subsidiary (S2) in the same country that is regarded and that is eligible for consolidation or group relief in such country. In the case of a loan from P to S1, deductible interest payments could be made by S1 to P which could reduce local tax in S2 under the Country S consolidation/group relief rules. The primary rule proposed by recommendation 3 would be for Country S to disallow the disregarded payment and the secondary rule would be for Country P to tax the disregarded payment. The rule would apply to all disregarded payments, not just interest, but, for example, rents, royalties, and service payments as well, to the extent that the deductible payment exceeds the so-called dual inclusion income that is recognized as taxable income in both countries. Sounds a lot like our U.S. dual consolidated loss rules, with the added twist of a recommended secondary rule that would override the effect of our U.S. check-the-box rules. Determining which country should act and to what extent would involve a complex interaction of the tax laws in Countries P and S due to the potential for differences in the computation of taxable income and expense items. The simple and clear approach taken in our U.S. dual consolidated loss rules (I'm kidding) would likely be a starting point, but with the need also to coordinate potentially dueling dual-consolidated-loss-like rules in the parent and subsidiary countries. Interestingly, recommendation 3 is the shortest of the 12 recommendations and only two specific examples are provided. Perhaps the OECD drafters have not fully considered the potential complexities or perhaps they are disinclined to go into as much detail in this area to ensure a workable rule because they feel that those who check-the-box do so at their own peril, which would seem to be blatantly targeting U.S. multinational corporations. Moreover, it seems to me that this rule would have lots of potential implications for branches and permanent establishments as well, which, if the Action 7 recommendations are implemented, will be a lot more prevalent in the future.
Recommendations 4 and 5 deal with reverse hybrids. In the U.S. context, think of a foreign entity treated as transparent locally (say, as a partnership) but as a corporation in the owner's country. U.S. LLCs owned by non-U.S. investors would seem also to be a typical example of a reverse hybrid. The report considers a payment to a reverse hybrid to create a hybrid mismatch to the extent there is a deductible payment made to the reverse hybrid and the related income is not taxable to the owner of the reverse hybrid. The rule recommended by the report is that the payer country should disallow deductions for the payments to the extent the income is not taxed to the reverse hybrid owner. As with the proposed disregarded payment rule, this would not apply only to interest payments, but presumably could apply also to rents, royalties, service payments, etc. Note that there is no secondary rule proposed in this case, although recommendation 5 does encourage jurisdictions to improve their CFC regimes in order to prevent this type of DNI outcome. The report makes clear in an example that, to the extent the income of a reverse hybrid is fully taxed under a CFC regime, the payer country should not treat the payment as a hybrid mismatch — with the burden of proving full current taxation falling on the taxpayer. In this regard, however, the inclusion of the reverse hybrid income in the investor country through a dividend payout rather than a CFC inclusion would not be satisfactory from the OECD's standpoint to trigger a turning off of the treatment of the arrangement as a hybrid mismatch.
The other design proposal in recommendation 5 is for countries to limit the tax transparency of an entity to the extent it is owned by foreign investors. So presumably they would propose that U.S. LLCs be taxed as corporations to the extent they are owned by non-U.S. persons. A pretty dramatic proposal for change. And one that feels more than a little discriminatory.
The dual resident proposals of recommendation 7 are aligned in concept with the disregarded payment proposals of recommendation 3 and again would have some similarity to our U.S. dual consolidated loss rules. But the rule proposed is for both countries in which a company is tax resident to disallow a deduction for a payment that could result in a double tax deduction, so there is no ordering rule as in the recommendations that use a primary and secondary rule approach. The report acknowledges that simultaneous application of the rule has the potential to create double taxation. But this potential outcome is dismissed since "structuring opportunities will usually be available to avoid the risk of double taxation." I don't feel particularly comforted by this. Perhaps they should at least admonish countries not to invoke their GAARs when a company is doing such a restructuring to avoid the double taxation that otherwise would arise. Maybe I am being paranoid, but the times seem to call for a little paranoia.
My "favorite" recommendation is number 8, the imported mismatch rule. This rule applies any time there is a deductible payment to a payee that benefits from a hybrid mismatch to reduce the payee's tax on the deductible payment. The rule can apply through unlimited tiers of related entities which would seem likely to cause incredible potential complexity and I could foresee enormous taxpayer burden in having to disprove the existence of any tainted imported mismatch anywhere in the chain of intercompany treasury transactions.
I think it's best to use one of the examples in the report to illustrate the potential scope of this rule. Example 8.7 seems a good (or perhaps bad is the right word) one to focus on. The facts are illustrated as follows:
[Image]So definitionally there is an imported mismatch involved here because C Co has made a hybrid payment to A Co – one might think in terms of a Luxembourg company with preferred equity certificates or PECs. The non-hybrid interest payments (direct or indirect) made by the other companies in the A Co group are all subject to potential disallowance, but only up to the amount of the hybrid mismatch payment. So which country gets to disallow the interest payment made by its local subsidiary? The proposal would focus on the country with the imported mismatch that is most direct, to the extent that country adopts the imported mismatch rule. The example assumes that Countries D, E, and F all adopt the imported mismatch rule and that the other Countries C, B, G, and H do not. In that case, Country D gets to disallow the full 200 interest payment to C Co, which matches the amount of the hybrid payment by C Co. Countries E and F would not get to disallow any interest payment because the hybrid mismatch has been neutralized by a disallowance to a less indirect borrower. If Country D did not implement the recommendation, Countries E and F could disallow the full 100 interest payment in each country, unless Countries G and H also implemented the recommendation, in which case they could each disallow a proportionate amount of their payments – in that case, since in total 400 of deductible payments would be implicated with only a 200 hybrid mismatch, each country could disallow 50 of the 100 interest payment.
Don't forget a hybrid mismatch for this purpose could arise from a hybrid instrument, a disregarded payment, a reverse hybrid or a dual resident company payment. The level of transparency, knowledge of foreign country rules, burden of proof, and implications of currency differences and valuation differences that would be involved are just a few quick reasons why this proposal seems totally unworkable. Drafting legislation and regulatory guidance to enact such a rule would seem nigh on impossible, much less actually administering it in practice. But take heart — "structuring opportunities will usually be available to avoid the risk of double taxation." That's starting to seem like a common theme – let's propose rules that are so unmanageable that hybrids can no longer exist. However, that unreasonable starting point presumes that hybrids are all optional and since we live in a world of disparate national rules, hybridity — good and bad, however you define what's good and what's bad — is a reality that can be unavoidable.
Just think for a moment about what statutory changes would be needed in the United States if the OECD recommendations were ever to be adopted. It seems to me that changes would be needed to §385, the foreign tax credit rules, §7701 with respect to LLCs and conduit financing, the check-the-box rules, the dual consolidated loss rules, and probably the withholding tax rules, as a start. Needless to say, I find it all hopelessly impractical and can't help thinking our well-intentioned colleagues at the OECD may have gotten carried away.
There are a few good (at least in relative terms) aspects of the report. It acknowledges that differences in statutory tax rates alone do not create hybrids – so even loans from a tax haven entity would not be affected by Action 2. Notional interest regimes that grant deemed deductions on all equity would not be affected because they are seen as an effective lowering of a country's statutory rate. Interest-free loans where a deemed deduction is granted in the borrowing country similarly would not be implicated. Of course, I would never have imagined that any of these structures could be considered hybrids, but after seeing how far the OECD was willing to go, it's nice to see confirmation of these points in the report.
Fortunately, all the recommendations in this report require local country action to take effect. Let's hope countries all think this through before blindly jumping on the BEPS bandwagon in respect to hybrids. But as I am writing to conclude this commentary, this hope is quickly fading as I have just read proposed U.K. legislation on "hybrid and other mismatches" which runs 48 pages and essentially proposes to wholesale adopt the unwieldy OECD recommendations, effective as of January 1, 2017. Naturally with "only" 48 pages rather than over 450 pages and without the benefit of the numerous OECD examples, there no doubt will be disconnects from the OECD construct. So there is a high risk of double tax occurring when other countries start adopting their own versions. And as this goes to press, even more disturbing is the proposal for an EU directive on BEPS generally which seems to attempt to put forth a principles-based, anti-hybrid approach that is very hard to understand but that one can be sure will create lots of problems if adopted.
The bottom line seems to be that 2016 should be a year of restructuring group treasury arrangements in order to avoid double tax risks and extended controversy.
This commentary also appears in the February 2016 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, and in Tax Practice Series, see ¶2330, Interest Expense, ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers.
Copyright©2016 by The Bureau of National Affairs, Inc.
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