Final OECD hybrids report creates more complexity and may affect investment decisions

Tax Policy Bulletin
Final OECD hybrids report creates
more complexity and may affect
investment decisions
23 November 2015
In brief
The OECD on 5 October 2015 issued its 458-page final report on ‘hybrid mismatch arrangements’ from
the base erosion and profit shifting (BEPS) project. The final report generally confirms the concepts and
recommendations in the September 2014 hybrids deliverable, along with many examples that make up
almost two-thirds of the report’s length. The domestic law recommendations create significant
complexity, particularly with respect to ‘imported mismatches.’ The report’s treaty recommendations
still have relatively limited scope.
The domestic law recommendations would apply to ‘payments’ from hybrid mismatch arrangements, but
not to deemed payments such as notional interest deductions. The report retains the principle of
automatic application for the rules, with no subjective motive or purpose test. The structure of primary
and defensive linked rules, with a hierarchy, has also been preserved. Generally, the recommendations
would require either payer jurisdictions to deny deductions for hybrid mismatch payments or payee
jurisdictions to include such payments as income. Some limited new exceptions have been added. The
report also provides enhanced guidance on both implementation of the rules and transitional
arrangements. These cover the complex situations that may arise in the appropriate counteraction
measures, depending on the arrangement and its effect.
It is unclear how widely the complex domestic law recommendations on hybrid mismatches will be
adopted. Some jurisdictions may enact all of the OECD’s concepts, but others may only use the rules that
are more easily administered. Unfortunately, non-uniform adoption could result in double taxation and
may impact investment decisions. Companies and other investors may hesitate to locate profitable
operations or make other substantial funding commitments in jurisdictions that apply these concepts in
a manner likely to result in double taxation. It appears unlikely that most jurisdictions will coordinate to
adopt these OECD recommendations in a genuinely multilateral manner. The Dutch government has
already stated that it will not unilaterally tighten regulations with respect to hybrids and will continue to
ensure that the Netherlands remains attractive for foreign investment.
The main features of the final hybrids report, including significant changes from the previous deliverable,
are set out below.
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In detail
Composition of the report
In Part I, the OECD recommendations
for domestic laws to address hybrids
are identified and categorised within
three types of hybrid mismatch
arrangements, which are identified
according to their tax effects.
Chapters 1-8 include the
recommendations for specific types of
hybrid mismatches. Chapter 9
addresses design principles for these
recommendations, as well as
implementation and transition
arrangements. Chapters 10-12
provide certain key definitions.
Unless otherwise noted, all definitions
provided are contained in Chapter 12.
Hybrid mismatch is not defined as a
general matter. Rather, it is
specifically defined for the purposes of
Recommendations 1, 3, 4, 6, and 7 in
each of those recommendations
(Paragraph 3). This diversity of
definitions reflects the overall
complexity of the report.
Recommendations for domestic
laws
Categories of hybrid mismatch
arrangements
The report's fundamental principles
have not changed from previous
drafts. The two main types of
mismatches identified are payments
that (i) are deductible under the rules
of the payer and not included in the
income of the recipient (deduction/no
inclusion or ‘D/NI’ outcomes) or (ii)
give rise to duplicate deductions from
the same expenditure (double
deduction or ‘DD’ outcomes).
D/NI outcome – A deduction/no
inclusion outcome arises where a
deduction is given for the company
making a payment while the receipt is
not fully taxable as ordinary income in
the hands of the payer. Timing
differences in the recognition of
2
payments or differences in the way
jurisdictions measure the value of
money do not, of themselves, generate
a D/NI outcome. The final report
clarifies, however, that a timing
mismatch may be considered
permanent (and thus subject to the
rule) if the taxpayer cannot establish
to the satisfaction of a tax authority
that it will recognize a payment within
a defined period.
Ordinary income – ‘Ordinary income’
is any income effectively subjected to
the full marginal tax rate in the
recipient’s territory of residence.
Income is viewed as taxable even if
there are other deductions available to
offset it. The final report has added
an exception allowing tax incurred
under a parent’s controlled foreign
corporation (CFC) regime to suffice,
although the report also treats foreign
tax credits as an offset that may
render income non-taxable for this
purpose.
DD outcome – A payment gives rise to
a DD outcome if the payment is
deductible under the laws of more
than one jurisdiction.
The third type of mismatch is where
non-hybrid payments from a third
country can offset hybrid mismatch
arrangement deductions and thus are
not effectively taxed in the recipient's
hands (an indirect deduction/no
inclusion or ‘indirect D/NI’ outcome).
Within these three categories of
hybrid mismatch arrangements are
the different types of hybrid
transactions and entities the report
specifically addresses:
 D/NI outcomes
(Recommendations 1-5)
–
Hybrid financial instruments
(including transfers):
covering deductible payments
made under a financial
instrument that is not taxed
as ordinary income in the
payee’s jurisdiction.
–
Disregarded hybrid entity
payments: covering
deductible payments that are
not taxed as ordinary income
in the payee’s jurisdiction
because the payee jurisdiction
does not recognise the
payment.
–
Payments made to reverse
hybrids: covering payments
made by an intermediary
payee where the differences in
characterisation of the
intermediary entity by its own
jurisdiction and its investor’s
jurisdiction results in the
exclusion of payments from
ordinary income in both of
those jurisdictions.
 DD outcomes (Recommendations
6-7)
–
Deductible hybrid entity
payments: covering
deductible payments made by
a hybrid entity that could
trigger a duplicate deduction
in the parent jurisdiction.
–
Deductible payments made
by a dual resident company:
covering payments made by a
company treated as a resident
by more than one jurisdiction.
 Indirect D/NI outcomes
(Recommendation 8)
–
Imported mismatch
arrangements: covering
arrangements where the
intermediary jurisdiction is
party to a separate hybrid
mismatch arrangement, and
the payment from another
jurisdiction to the
intermediary jurisdiction
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Tax Policy Bulletin
under a non-hybrid
arrangement offsets a
deduction arising under the
hybrid mismatch
arrangement to which the
intermediary is a party.
Payments – Defined broadly as any
amounts capable of being paid,
including accrued amounts that will
ultimately be payable. Payments that
are only deemed to arise for tax
purposes are specifically excluded;
there is an example of notional
interest deductions for equity. The
definition is not limited by reference
to financial payments and so would
include, for example, rent, royalties
and payments for services.
Observation: Presumably, the
exception for payments deemed to
arise for tax purposes would cover all
such amounts and not just notional
interest deductions for equity, which
is the example given.
Arrangement – Broadly defined as an
agreement, contract, scheme, plan, or
understanding, whether enforceable
or not, including all steps and
transactions by which it is carried into
effect. An arrangement may be a
single arrangement, part of a wider
arrangement or comprised of a
number of arrangements.
The recommendations only apply to
payments that result in a hybrid
mismatch. The recommendations
have a common format, which
includes a Primary Rule, a Defensive
Rule (for another jurisdiction to apply
where the Primary Rule is not in
place), specifications for the types of
entities and payments subject to the
rule, and the scope of situations to
which the rule applies.
Recommendation 1: Hybrid financial
instrument rule
Recommendation 1 is an extensive
rule addressing payments under a
financial instrument that result in a
hybrid mismatch. Its complexity is
reflected in Annex B of the report,
which sets forth 37 examples related
to this rule.
The Primary Rule for
Recommendation 1 is that the payer
jurisdiction denies the deduction to
the extent it gives rise to a D/NI
outcome. (See Example 1 below.) To
the extent the payer jurisdiction does
not deny the deduction, under the
Defensive Rule the payee jurisdiction
should ensure that the payee includes
the payment in ordinary income.
Example 1
Country A
No income
recognised
Country B
Deduction
Hybrid
instrument
payment
For purposes of this rule, a ‘hybrid
mismatch’ only comes into play where
the mismatch can be attributed to the
instrument's terms. (See Example 2
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below.) A payment cannot be
attributed to the instrument's terms
where the mismatch is solely
attributable to the taxpayer's status or
the circumstances in which the
instrument is held.
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Example 2
Country A
Tax-Exempt
Fund
Income
exempted
Country B
Deduction
Financial
instrument
payment
Observation: The report clarifies
that the hybrid financial instrument
rule only applies where the hybrid
mismatch is attributable to the terms
of the instrument itself. However, an
arrangement may give rise to a hybrid
mismatch under other rules in this
report due to the taxpayer's status or
the circumstances in which the
instrument is held.
Recommendation 1 applies to both
hybrid financial instruments and
hybrid transfers.
A ‘financial instrument’ is defined as
any arrangement that both the payer
and payee jurisdictions tax under the
rules for taxing debt, equity or
derivatives. The report has expanded
the scope of this definition, stating
that a jurisdiction should treat any
arrangement where one person
provides money to another in
consideration for a financing or equity
return as a financial instrument (to
the extent of that return).
Furthermore, following the
counteraction principle, any payment
that the counterparty jurisdiction does
not treat as a financial instrument
would be treated as giving rise to a
mismatch -- but only to the extent the
payment constitutes a financing or
equity return. Finally, a ‘substitute
payment’ would be a payment that
includes or represents a financing or
equity return on a financial
instrument that is subject to a transfer
arrangement, where the payment or
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return (i) would not have been
included in the payer’s ordinary
income; (ii) would have been included
in the payee’s ordinary income; or (iii)
would have given rise to a hybrid
mismatch, if it had been made directly
under the financial instrument.
‘Hybrid transfers’ include any
arrangement to transfer a financial
instrument where the taxpayer is the
owner (legal or beneficial) of the
transferred asset and the taxpayer’s
jurisdiction treats the counterparty’s
rights in that asset as the taxpayer’s
obligations, but the counterparty’s
jurisdiction treats the counterparty as
the owner and the taxpayer’s rights as
the counterparty’s obligations.
The hybrid financial instrument rule
would apply only to instruments and
transfers entered into with related
parties or in structured arrangements.
Related persons – As defined in
Recommendation 11, two persons are
related if they are in the same ‘control
group’ or have at least 25% common
ownership (directly or indirectly, by
vote or value). Being in the same
control group means (i) they are
consolidated for financial accounting
purposes, (ii) one person has effective
control over the other (or a third
person over both), (iii) one person has
at least a 50% investment in the other
(directly or indirectly, by vote or
value), or (iv) they can be regarded as
‘associated enterprises’ under the
OECD Model Treaty’s Article 9.
Observation: The ‘related person’
threshold has been retained from the
prior deliverable, where it was
increased from 10% in the first
discussion draft. Some observers feel
that 25% common ownership is still
too low, since it would not normally
be high enough to allow the owner to
determine business or tax
arrangements, absent other factors.
Structured arrangement – As defined
in Recommendation 10, a ‘structured
arrangement’ is one where (i) the
hybrid mismatch is priced into the
terms of the arrangement or (ii) the
facts and circumstances (including the
terms) of the arrangement indicate
that it has been designed to produce a
hybrid mismatch. The report specifies
that structured arrangements include
arrangements that:
 are designed to create a hybrid
mismatch
 incorporate a term, step or
transaction to create a hybrid
mismatch
 are marketed as products with a
tax advantage deriving from a
hybrid mismatch
 are primarily marketed to
taxpayers in a jurisdiction where
the hybrid mismatch arises
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 provide a contingency modifying
the arrangement should a hybrid
mismatch no longer be available
 would produce a negative return
absent a hybrid mismatch.
Taxpayers would not be party to a
structured arrangement if they were
not aware of the hybrid mismatch and
did not recognise any tax benefit from
it.
The final report retains an exception
to the hybrid financial instrument rule
where the payer jurisdiction’s tax
policy for the deduction is to preserve
tax neutrality for the payer and payee.
The exception addresses a payment by
an investment vehicle (if not made
under a structured arrangement) that
is subject to the establishment
jurisdiction’s special regulation and
tax treatment, as follows:
investment income being paid and
distributed to the holders of those
financial instruments within a
reasonable period of time after the
taxpayer received that income.
 The deduction for the payment is
preserved to ensure that the
taxpayer is subject to minimal (or
no) taxation on its investment
income, while holders of financial
instruments issued by the taxpayer
are subject to current tax on that
payment as ordinary income.
 The full amount of the payment is
(i) included in the ordinary income
of any person that is a payee in the
establishment jurisdiction and (ii)
not excluded by a tax treaty from
the ordinary income of any person
that is a payee under the laws of
the payee jurisdiction.
 The investment vehicle’s financial
instruments will result in
substantially all of the taxpayer’s
This exception applies to special
entities such as real estate investment
trusts (REITs). (See Example 3
below.)
Example 3
No dividend
exemption
Other
Investors
Country A
Dividend
25%
Country B
REIT
The final report reflects further work
where the OECD addressed various
issues relating to financial
instruments, entities, and
transactions. This work includes
considerations of repos and stock
lending, on which the report offers
five examples.
Observation: There is an
outstanding question on how repo or
stock lending transactions should be
treated for banks, funds and financial
traders. While the OECD has
provided additional guidance, there
are still a number of points to
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consider, particularly for intra-group
arrangements that are not excluded.
Given the importance of repo and
stock lending as a source of shortterm financing for the financial sector,
this will be a key area of concern for
most financial institutions with crossborder funding arrangements on
which the OECD should provide
clarity. For example, the compliance
burden of demonstrating that all stock
loans and repos either (i) are not
structured arrangements (to which the
rules apply, even in third-party
situations) or (ii) do not give rise to
any hybrid mismatches with counter-
parties could be extremely difficult,
not least given the size of the repo and
stock lending markets.
Certain issues regarding financial
instruments still remain open. In
particular, the report’s Executive
Summary notes that jurisdictions are
free to decide whether or not hybrids’
rules should apply to mismatches
from intra-group hybrid regulatory
capital, without regard to whether
other jurisdictions do so.
Observation: For financial
institutions, instruments issued for
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regulatory capital purposes often have
hybrid instrument characteristics.
In practice, externally-issued
instruments will generally not be
caught by hybrids' rules, since they are
unlikely to be ‘structured
arrangements’. However, where there
has been an intra-group pushdown of
externally-issued instruments,
financial institutions should evaluate
whether there could be unintended
adverse consequences.
Note that a variety of common fact
patterns that give rise to a D/NI result
would not be subject to
Recommendation 1, to the extent they
are not hybrid mismatches under
terms of a financial instrument.
Observation: The rules in
Recommendation 1 could affect a
variety of intragroup hybrid
instruments that some multinationals
might use from a US company to a
non-US company or between non-US
companies. To the extent that an
instrument operates only between two
EU companies, it would generally be
subject to the amended ParentSubsidiary Directive, which must be
enacted into domestic law by 31
December 2015. The EU has taken an
approach that resembles
Recommendation 2 (see below) more
than Recommendation 1.
To prevent any duplication of tax
credits under a hybrid transfer, the
report also recommends that any
jurisdiction granting relief for tax
withheld at source on a payment made
under a hybrid transfer should restrict
the benefit of such relief in proportion
to the taxpayer’s net taxable income
under the arrangement.
Recommendation 2: Specific
recommendations for the tax
treatment of financial instruments
Observation: The participation
exemption rule is similar to the EU’s
approach in amending the ParentSubsidiary Directive.
Recommendation 2 provides an
additional domestic law approach to
address D/NI arrangements, with no
limitation as to scope. Specifically,
where domestic law generally provides
for a participation exemption, the
OECD suggests that jurisdictions
should not grant such an exemption
for all dividends (not only relatedparty dividends) that have given rise
to a deduction in another jurisdiction.
Recommendation 3: Disregarded
hybrid payments rule
For disregarded hybrid payments,
Recommendation 3 suggests that,
under the Primary Rule, the payer
jurisdiction should deny the
deduction. (See Example 4 below.) If
the payer jurisdiction does not deny
the deduction, then, under the
Defensive Rule, the payee should
include the payment in ordinary
income.
Example 4
Country A
No income
recognised
Country B
Deduction
Payment
The rule does not apply to the extent
the deduction offsets dual inclusion
income (income subject to tax as
ordinary income in both the payer and
payee jurisdictions). Excess
deductions may be carried forward
and offset future dual inclusion
income.
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The rule will only operate where a
hybrid payer makes a disregarded
payment. A hybrid payer is a person
where the tax treatment of the payer
(by the payee jurisdiction) causes the
payment to be disregarded. A
disregarded payment is a payment
that is deductible in the payer
jurisdiction but not included in
income by the payee jurisdiction. The
rule applies only to payments (i)
between related persons in the same
control group or (ii) made under a
structured arrangement to which the
taxpayer is a party.
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Observation: This recommendation
would clearly impact certain first-tier
disregarded intragroup loans that
some US multinationals might use.
Recommendation 4: Reverse hybrid
rule
Under Recommendation 4’s Primary
Rule for payments to reverse hybrids,
the payer jurisdiction denies the
deduction to the extent it gives rise to
a D/NI outcome. There is no
Defensive Rule. (See Example 5
below.)
Example 5
Parent
No income
recognised
Country
A
Payment
Country B
Although the OECD uses the US term
‘reverse hybrid,’ the term does not
have the same meaning as under US
federal income tax law. Rather, a
reverse hybrid is defined as any entity
that is treated as a separate entity by
any investor and as transparent under
the laws of the establishment
jurisdiction.
The reverse hybrid rule would apply
only where a payment results in a
hybrid mismatch that would not have
arisen had the accrued income been
paid directly to the investor. Its scope
is limited to situations where the
investor, the reverse hybrid and the
payer are members of the same
control group, or if the payment is
part of a structured arrangement to
which the payer is a party.
Observation: Recommendation 4
could have unexpected effects on
certain structures, where a
transparent entity’s indirect investor
may be located in a jurisdiction that
sees the entity as separate, even
though intermediate jurisdictions in
the chain also see the entity as
transparent. The rule could also affect
certain structures involving top-tier
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reverse hybrids that some
multinationals might use.
Recommendation 5: Specific
recommendations for the tax
treatment of reverse hybrids
Recommendation 5 provides three
general suggestions for domestic law
changes addressing issues raised by
reverse hybrid arrangements:
 Instituting or improving offshore
investment (CFC) regimes to
prevent D/NI outcomes from
arising with respect to payments to
a reverse hybrid (or in relation to
imported mismatch
arrangements). Specific
suggestions for possible
improvements include changes to
residency rules, CFC rules and
rules that tax a resident investor on
changes in an investment's market
value.
 Limiting tax transparency for
non-resident investors. The report
recommends treating reverse
hybrids as resident taxpayers in the
establishment jurisdiction if the
reverse hybrid’s income is not
otherwise taxable in that
jurisdiction and the accrued
income of a non-resident investor
in the same control group is not
taxable in the investor jurisdiction.
 Information reporting for
intermediaries. The OECD
recommends that jurisdictions
introduce appropriate tax filing
and information reporting
requirements on persons
established within their
jurisdiction in order to assist both
taxpayers and tax administrations
to properly determine the
payments that have been attributed
to that non-resident investor.
Observation: The report addresses
a controversial issue in previous drafts
by treating a payment that is included
as income in the parent jurisdiction
under a CFC regime as if it had been
included in ordinary income by the
payee (beyond any offsets to the CFC
inclusion). The report signals,
though, that the OECD will continue
to work on the interaction between
hybrids rules and CFC regimes.
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Recommendation 6: Deductible
hybrid payments rule
Recommendation 6 addresses
payments by a ‘hybrid payer’ that are
deductible both in the payer
jurisdiction and in the parent
jurisdiction. The Primary Rule, with
no scope limitation, is for the parent
jurisdiction to deny the duplicate
deduction to the extent it gives rise to
a DD outcome. (See Example 6
below.) The Defensive Rule is for the
payer jurisdiction to deny the
duplicate deduction, to the extent it
gives rise to a DD outcome. That rule
would apply only if the parties to the
mismatch are in the same control
group or a structured arrangement.
Example 6
Unrelated
X
Country A
Deduction
Country B
Deduction
Payment
A hybrid payer for this purpose is a
person making a payment that is
deductible under the laws of the payer
jurisdiction where (i) the payer is not
a resident of the payer jurisdiction
and the payment triggers a duplicate
deduction for that payer (or a related
person) under the laws of the
jurisdiction where the payer is
resident (the parent jurisdiction); or
(ii) the payer is resident in the payer
jurisdiction and the payment triggers
a duplicate deduction for an investor
in that payer. The rule does not apply
to the extent the deduction offsets
dual inclusion income, as defined
above. (See Example 7 below.)
Example 7
Partial income inclusion
Country A
Partial
X
Deduction
Partial income inclusion
Unrelated
Country B
Payment
Excess deductions, beyond dual
inclusion income amounts, may be
carried forward and offset future dual
inclusion income. To prevent stranded
losses, the excess deduction may be
allowed to the extent that the taxpayer
can show that the deduction in the
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other jurisdiction cannot offset any
person’s income.
Recommendation 7: Dual resident
payer rule
Recommendation 7 covers payers that
are dual consolidated companies, that
is, taxpayers considered a tax resident
by two or more jurisdictions. This
rule addresses such companies’
payments that are deductible under
the laws of more than one of those
jurisdictions. The Primary Rule is for
all of the payer’s resident jurisdictions
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to deny the duplicate deduction, to the
extent it gives rise to a DD outcome.
There is no scope limitation for this
recommendation and no need for a
Defensive Rule.
As with Recommendation 6, this rule
does not apply to the extent the
deduction offsets dual inclusion
income. Excess deductions (beyond
dual inclusion amounts) may be
carried forward and offset future dual
inclusion income. The excess
deduction may be allowed to the
extent that the taxpayer can show that
the deduction in the other jurisdiction
cannot offset any person’s income.
Observation: The rules in
Recommendations 6 and 7 are very
similar in concept to the US dual
consolidated loss (DCL) rules. The
DCL regime is very complex (US
regulations in this area are 61 pages
long), and one could expect this rule
to provide similar challenges for both
taxpayers and tax authorities.
Recommendation 8: Imported
mismatch rule
Recommendation 8 addresses
‘imported mismatches’. These are
defined as arrangements that give rise
to a hybrid mismatch under the laws
of another jurisdiction, and the effect
of that mismatch is imported into the
payer jurisdiction by offsetting the
deduction under that hybrid
mismatch arrangement against the
income from the payment. An
imported mismatch payment is a
deductible hybrid mismatch payment
made to a payee that is not subject to
hybrid mismatch rules.
The Primary Rule is for the payer’s
jurisdiction to deny the deduction, to
the extent the payment gives rise to an
indirect D/NI outcome. Specifically,
the OECD recommends that the payer
jurisdiction apply a rule denying a
deduction for any imported mismatch
payment pro rata, that is, to the extent
the payee treats that payment as an
offset to a hybrid deduction in the
payee jurisdiction. (See Example 8
below.)
Example 8
Parent
100
interest
No
income
recognised
Reverse
Hybrid
Country B
Deduction
Country B
100
interest
Country C
For this purpose, a ‘hybrid deduction’
means a deduction resulting in a
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hybrid mismatch that derives from: (i)
a payment under a financial
instrument; (ii) a disregarded
payment made by a hybrid payer; (iii)
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a payment made to a reverse hybrid;
or (iv) a payment made by a hybrid
payer or dual resident that triggers a
duplicate deduction, and includes a
deduction resulting from a payment
made to any other person to the extent
that person treats the payment as an
offset to another hybrid deduction.
The rule would apply only where (i)
the taxpayer is in the same control
group as the parties to the imported
mismatch arrangement, or (ii) the
payment is made under a structured
arrangement, and the taxpayer is
party to that structured arrangement.
There is no Defensive Rule.
Observation: Recommendation 8 is
likely to be the source of greatest
complexity for both taxpayers and tax
authorities. It asks for extensive
knowledge of multiple jurisdictions’
tax laws, as well as the facts and
circumstances of every person that
may be viewed under the relevant tax
laws as part of an imported mismatch
situation. This rule could lead to an
unfavorable asymmetry for taxpayers.
For example, a taxpayer may be
denied a deduction even if an
imported mismatch results in a CFC
inclusion in the investor jurisdiction.
(See Example 9 below.)
Example 9
Parent
100
ordinary
income
(under CFC
rules)
Reverse
Hybrid
100
interest
Country A
100
interest
Country B
In general, taxpayers will need to
prove income inclusions in
intermediary or investor jurisdictions
(or a denial of deductions in an
intermediary jurisdiction) to avoid
denial of a deduction in the nonhybrid payer country. It is easy to see
that there will be enormous
complexity in applying the pro rata
deduction denial rule in many
situations. For example, imagine that
Country A company above is a
treasury company making multiple
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loans, from multiple sources, in
multiple currencies to multiple
borrowers. There will also be
difficulties in obtaining information
from all participating non-controlled
parties in a structured transaction.
Some jurisdictions possibly may find
this rule too difficult to administer
and may decline to adopt these
imported mismatch rules; uneven
adoption is likely to result in double
taxation. The complexity that
Recommendation 8 could generate,
especially where there is non-uniform
adoption, is demonstrated in Example
10 below. This example assumes that
countries may adopt the hybrid
mismatch rule and all its complexities
fully, partially, or not at all. Such nonuniform adoption can lead to double
taxation when countries that fully or
partially adopt the rule deny more
than their appropriate share of a
deduction:
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Example 10
Taxexempt
investors
50 equity
25 loans
75 hybrid
loans
Other
investors
CIV
(Country A)
50 equity
25 loans
75 hybrid
loans
300 cash
Fiscal unity
100 loan
100 loan
Pro rata
denial
(75)
X
Deduction
100 loan
Country A
Country B
Full
denial
(100)
Country C
Country D
X
Deduction
Deduction
This shows that the countries involved
may adopt imported mismatch
measures with no pro rata rule (as it is
too complex) or not enough
information to apportion correctly or
by applying it wrongly, thus denying
too much and resulting in double
taxation. The guidance states that the
process might be better if
multinationals do the necessary
calculations and present them to the
relevant tax administrations.
Treaty issues
Scope of provisions
The OECD has made
recommendations to ensure that
hybrid instruments and entities are
not used to obtain treaty benefits
inappropriately. The
recommendations cover the following
situations, set out in more detail
below:
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 dual resident entities
 transparent entities, and
 interaction between the domestic
hybrid (and other)
recommendations and tax treaty
provisions.
Dual resident entities
Domestic legislation
Recommendation 7 above deals with
counteractions related to payments
involving dual residents. However,
there is a proposal to widen the
existing dual resident tie-breaker rule
(Article 4(3)) under the Model Treaty.
The revised rule would state that
residence in such cases should be
determined not only by place of
effective management, but also by
place of incorporation or constitution
and ‘other relevant factors’.
Observation: The inclusion of such a
broader clause creates subjectivity and
greater uncertainty for business. For
example, a lack of agreement between
two jurisdictions results in no relief
except as agreed by the competent
authorities. The intent is to have, in
effect, a case-by-case analysis but
instead may lead to protracted
disputes.
To supplement this, the OECD
suggests that countries may consider a
rule that an entity that is considered
to be a resident of another state under
a tax treaty, under the expanded rule,
will be deemed not to be a resident
under domestic law (this applies if
other anti-abuse rules insufficiently
address mismatches between the
treaty and domestic law concepts of
residence.)
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Example 1: State A has a 25% tax
rate, State B has a 15% tax rate.
Entities 1 and 2 are resident in State
A under the domestic law of that
state. Entity 1 is resident in State B
under domestic law in that state and
under the A-B treaty (as adjusted in
relation to the Article 4(3) BEPS
amendment). If Entity 1 makes a
profit in State B, it may under the A-B
treaty be taxable only in State B at
15%. If Entity 1 incurs a loss in State
B, the concern is that it could, under
the tax consolidation rules in State A,
offset that loss against profits of
Entity 2, effectively obtaining relief at
25%. Including such a domestic rule
in State A that would make Entity 1 a
non-resident there deals with this
situation.
Example 2: State A has a 25% tax
rate, State B has a 15% tax rate.
Entity 1 is resident in State A under
the domestic law of that state. Entity
2 is resident in State B under the
domestic law of that state. Entity 3 is
resident in both State A and State B
under the domestic laws of those
states. If Entity 3 incurs a loss, the
concern is that the loss could
effectively be taken into account
under the tax consolidation rules of
both State A and State B, reducing the
taxable profits of Entity 1 and Entity
2. (This is similar to the situation in
Example 7.1 in relation to payments
involving a dual resident.)
2A - If an A-B treaty existed, and the
domestic law of each state included
such a domestic rule, Entity 3 would
likely be a resident for the purposes of
domestic tax consolidation in only
one state, i.e. the state of which it
would be a resident under the treaty.
2B - If only one of the states includes
such a domestic rule, a difficulty
potentially arises – say, State A has
the rule while State B does not, Entity
3 might be considered under the A-B
treaty to be resident in State A rather
than State B and the rule does not
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apply since Entity 3 is not considered
to be a resident of State B under a tax
treaty, so continues to be resident for
the purposes of domestic tax
consolidation in both states.
Observation: The inclusion of a
non-residency domestic provision of
this type creates greater certainty for
business and tax administrations. A
number of jurisdictions have already
implemented (such as the United
Kingdom) or considered such a
provision recently.
Transparent entities
The OECD recommends widening the
existing Model Treaty rule with
regards to persons covered (Article 1))
to ensure that a transparent entity's
income attracts tax treaty benefits in
appropriate cases, but also that these
benefits are not granted where neither
Contracting State treats, under its
domestic law, that entity's income as
one of its residents' income.
The Model Treaty Commentary will be
enhanced accordingly. It will
specifically refer to the principles
reflected in the 1999 report of the
Committee on Fiscal Affairs entitled
‘The Application of the OECD Model
Tax Convention to Partnerships',
which was imported into the
Commentary. The guidance and
examples in that report on how to
interpret and apply the provision in
various situations for partnerships
would therefore be extrapolated to
other transparent entities with
appropriate modifications. That
includes a degree of continuity, but in
other respects makes interpretation
more difficult.
Observation: Taxpayers may incur
tax up-front and may seek a refund,
with the inherent delays that may
entail. States will in some respects be
encouraged by the guidance to take
that approach since they will not be
“expected to grant the benefits of a
bilateral tax convention in cases
where they cannot verify whether a
person is truly entitled to these
benefits.”
This applies for the purposes of treaty
interpretation (e.g., withholding tax or
WHT) and does not, therefore, require
a state to change the way in which it
attributes income or characterises
entities for the purposes of its
domestic law.
Example 1: Entity 1, established in
State B, is regarded under State A
domestic law as a company and a
partnership in State B ‘owned’
equally by members Entity 2 and
Entity 3. Entity 2 is a resident of
State B and Entity 3 is a resident of
State C. A payment of 100 by a
resident of State A to Entity 1 prima
facie attracts WHT at State A’s
domestic rate of 20%.
Under the A-B Treaty, half of the
potential receipt of 100 by Entity 1 is
considered to be income of a resident
of State B for WHT purposes. So 50
will attract WHT at 20% and 50 will
attract WHT at the reduced 10% rate
under the A-B Treaty. But Entity 1
remains the relevant taxpayer for the
purposes of State A’s domestic law.
However, where an entity is treated as
partly fiscally transparent under the
domestic law of one of the Contracting
States, part of the entity's income
might be taxed at the level of the
persons who have an interest in that
entity, while part would remain
taxable at the entity level. The revised
Commentary provides an example of
some rules for trusts where the part of
the income derived through a trust
that is distributed to beneficiaries is
taxed in the hands of these
beneficiaries, while the part of that
income that is accumulated is taxed in
the hands of the trust or trustees.
The Commentary will be amended to
clarify the meanings of 'income
derived by or through an entity or
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arrangement', 'income' and 'fiscally
transparent'.
Interaction between domestic rules
and treaties
The report acknowledges the need to
coordinate the Model Treaty with
domestic law BEPS recommendations.
The report notes that under Action 6
(Preventing Treaty Abuse) a number
of specific recommendations may play
an important role in ensuring that
hybrid instruments and entities (as
well as dual resident entities) are not
used to obtain treaty benefits unduly.
It highlights the following provisions
that may be of particular relevance:
 limitation-on-benefits (LOB) rules
and/ or the principal purpose test
(PPT)
 rules aimed at dividend transfer
transactions (i.e., to subject the
lower rate of tax provided certain
treaty provisions to a minimum
shareholding period)
 rules concerning a Contracting
State’s right to tax its own
residents
 anti-abuse rules for permanent
establishments situated in third
states.
It also considers the extent to which
Recommendations 1-12 above have
potential consequences for the
countries adopting them. It notes that
problems could arise for treaties that
allow the exemption method to apply
with respect to dividends received
from foreign companies and describes
possible treaty changes that would
address them. It largely concludes
that otherwise there are no interaction
issues concerning:
 denial of a deduction
 inclusion of a payment in ordinary
income
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 the elimination of double taxation
 non-discrimination (as long as the
domestic rules that will be drafted
to implement these are effectively
worded).
Observation: The interaction
between particular provisions in both
domestic and international tax rules
has proven difficult to predict.
Thankfully, the OECD has considered
and opined on a number of specific
issues, but practical issues likely will
need to be addressed when they arise.
Implementation and timing
Start and transition
The final recommendations do not
include any specific start date or
transition rules. These should be
determined as agreed in
Recommendation 9.2:
 the recommendations state
transition rules will be without any
presumption of grandfathering
existing arrangements
 when an effective date is agreed,
the report states that it should be
far enough in advance “to give
taxpayers sufficient time to
determine the likely impact of the
rules and to restructure existing
arrangements to avoid any adverse
tax consequences associated with
hybridity”
 all payments under hybrid
mismatch arrangements that are
made after the effective date of the
legislation or regulation should
then be affected according to the
report – to avoid unnecessary
complication and the risk of double
taxation, the report suggests the
rules should generally take effect
from the beginning of a taxpayer’s
accounting period.
Observation: These issues are
important, given the many existing
arrangements involving hybrid
transfers and entities. Any changes to
an existing arrangement may create a
substantial cost to businesses and
require time to adapt to the proposed
recommendations.
Drafting
The report recognises that the
wording of relevant legislation or
regulations will have to be specific to
each jurisdiction, bearing in mind the
existing legislative structure and
nature of the rule of law – one of the
‘design principles’ in
Recommendation 9.1. The measures
should also “minimise the disruption
to existing domestic law”.
When implementing these
recommendations, jurisdictions have
been encouraged to ensure the
counter measures also minimise the
administrative burden for taxpayers
and tax authorities. In particular, the
report specifies that the rules should
be comprehensive, clear and
transparent.
The counter measures a jurisdiction
introduces should apply automatically
and aim to neutralise the mismatch
between jurisdictions rather than
reverse the tax benefit that arises
under the laws of that particular
jurisdiction.
Observation: The lack of a motive
or purpose test in the
recommendations may create
unintended consequences. There is
also a lack of recognition that a
jurisdiction's anti-hybrid rules are just
one part of the overall fiscal policy of a
jurisdiction that has been set to
achieve the jurisdiction's specific
economic aim. In that sense,
jurisdictions might consider them
from a policy perspective in the same
way as other tax and non-tax levers
such as, for example, the overall
corporate tax rate, tax incentives and
legal and fiscal governance.
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Co-ordination within the anti-hybrid
rules
The report recommends that a
jurisdiction focus on ensuring coordination of its anti-hybrid rules (as
well as the interaction with other rules
applicable in the jurisdiction, as noted
below). Note that jurisdictions will be
co-operating on how to ensure these
recommendations are implemented
and applied consistently and
effectively across states. The extent of
the required coordination activity
indicates one area of complexity in the
implementation process:
 applying the hybrid mismatch
recommendations in the following
order of precedence: hybrid
financial instrument rule; reverse
hybrid rule/ disregarded hybrid
payments rule; imported mismatch
rule; and deductible hybrid
payments rule/dual resident entity
rule
 considering specific measures for
certain situations (e.g., financial
instruments) where there may or
may not be a mismatch in
outcomes between jurisdictions
 any relationship with existing antihybrid or anti-arbitrage rules
(unless those are to be repealed)
 applying the primary and
secondary rules appropriately,
particularly where the rules apply
in situations where the
counterparty jurisdiction
introduces hybrid mismatch rules
from a date that is part way
through the taxpayer’s accounting
period (the ‘switch-over period’).
The switch-over period
recommendation is, in relation to a
cross-border payment, that:
“(a) The secondary or defensive rule
will apply to any amount that is
treated as paid, under the laws of the
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payee jurisdiction (Country A), in a
period prior to the commencement of
the switch-over period.
(b) The primary rule will apply to any
amount that is treated as paid, under
the laws of the payer jurisdiction
(Country B), during the switch-over
period (after taking into account any
amounts caught by the secondary rule
in accordance with paragraph (a)
above).
(c) Any other payments that give rise
to a hybrid mismatch and that are not
captured by paragraph (b) above will
be caught by the application of the
secondary rule.”
Example: Entity 1 in Country A has a
calendar year accounting period
during which it receives annually
from Entity 2 in Country B a
payment of 200 under a hybrid
financial instrument. Country A has
adopted the hybrid recommendations
for some time (and has therefore
taxed the income under the secondary
rule) while Country B adopts the
hybrid recommendations with effect
from its tax year beginning 1 April in
that year. Country A applies the
accrual basis to a payment of this
kind while Country B has a more
complex revenue/ expense
recognition process.
In Entity 2’s tax computation in
Country B, as a result of the adoption
of the hybrid recommendations a
deduction is denied for say 140, being
the interest that arises during the
switch-over period (say 190) less the
portion of the payment that has been
taken into account in Country A prior
to 1 April (50).
In Entity 1’s tax computation in
Country A, the income will be taxed to
the extent the mismatch has not been
eliminated by the primary rule in
Country B, so 60. (The report states
that if, in practice, it would be unduly
burdensome to require Entity 1 to
determine the actual amount of the
payment that has been subject to
adjustment in Entity 2 in Country B,
the amount to be taxed in Entity 1 can
be calculated based on the amount
accrued under Country A law for the
switch-over period where the
primary rule will not apply i.e., 1
January to 30 March, so it would
seem 50).
Observation: There is considerable
complexity in how countries should
apply these rules to multinationals,
particularly where the tax years/
accounting periods are not
coterminous or countries’ rules are
not identical. The examples in the
report will need to be supplemented
further with more explicit examples if
they are to deal with various situations
that will arise in practice.
Interactions with other rules
The report refers to the need to:
 co-ordinate the hybrid mismatch
rules and other transaction specific
rules and other anti-abuse rules to apply consistently with other
rules of the domestic tax system so
that the interaction does not result
in double taxation of the same
economic income, and
 co-ordinate with the rules in a
third jurisdiction (such as CFC
rules) which subject payments to
taxation in the residence state of
the investor.
In particular, the report acknowledges
that interaction exists between this
and related Actions in the OECD
BEPS process, specifically Actions 3
(on strengthening CFC rules) and 4
(on limiting base erosion via interest
deductions and financial payments).
The OECD and the European
Commission (EC) have consistently
stated that the EC has been actively
involved in the BEPS deliverables and
ensuring compliance with the Treaty
on the Functioning of the EU and /or
EEA agreement in intra-EU/EEA
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cases. The application of EU law to
the proposed recommendations is
however complex. For example,
recommendations for the D/NI and
Indirect D/NI outcomes might
potentially be seen as discriminatory
measures under such EU law to the
extent that they are regarded as rules
that only operate with respect to cross
border situations and with respect to
non-taxation in the payee state. If so
they may still be justifiable on
‘Cadbury grounds’ where they are
limited to ‘wholly artificial
arrangements’. It is not clear whether
the EC would view hybrid
arrangements generally as being
wholly artificial within this context or
whether they may consider the rules
justifiable on other grounds (e.g.,
coherence and/or allocation of taxing
powers). Furthermore, as regards the
DD rules, it is not clear that the
defensive rule denying a deduction in
the payer jurisdiction is consistent
with the decision in Phillips
Electronics. This suggests that the
payer jurisdiction should not seek to
deny a deduction based on treatment
in an investor jurisdiction.
Observation: Having identified the
interaction with measures on interest
deductibility and CFCs, there is an
added complication in having hybrids
rules that apply in these situations.
Further, while the acknowledgement
of potential interaction between
measures under different action items
is welcome and essential, some crossover might also be considered in
relation to other Actions – 5 (on
harmful tax practises), 6 (on treaty
benefits) and, potentially 12
(disclosure of aggressive tax
planning).
Continuing review and exchange
The OECD will continue to review the
effective and consistent
implementation of the
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recommendations in accordance with
Recommendation 9.2 and the
commitments made in that section.
The OECD recognizes the need for a
regular exchange of information
between jurisdictions on their
treatment of hybrid arrangements
(e.g., through the Joint International
Tax Shelter Information Centre, or
JITSIC) and of spontaneous exchange
related to specific taxpayer
circumstances (via legal instruments
such as tax treaties, Tax Information
Exchange Agreements (TIEAs) and
the Convention on Mutual
Administrative Assistance in Tax
Matters (OECD 2010)).
The report notes that tax
administrations (and the OECD)
should make relevant information
available to taxpayers. The guidance/
commentary included in the report,
and the commitments made to update
it ‘periodically’, is intended to help
taxpayers as well as tax
administrations. The report suggests
that there is also an onus on
individual tax administrations to
ensure taxpayers are aware of the
treatment of hybrid arrangements
under their domestic laws, but some
have historically been much better at
doing this than others.
Observation: There is a concern
over the complexity and workability of
rules that require taxing authorities to
know, in detail, the taxation treatment
in other jurisdictions. Taxpayers in
some jurisdictions may not be
confident that their tax administration
would publish detailed guidance on
the operation of their domestic antihybrid rules.
The takeaway
adding many examples and some
exceptions. In particular, a new
exception prevents the denial of
deductions to the extent that a hybrid
mismatch payment is included as
ordinary income under the CFC
regime of the investor's home
jurisdiction.
The report’s treaty recommendations
have limited scope, but the domestic
law recommendations create
significant complexity, particularly
with respect to ‘imported
mismatches’. It is unclear how many
jurisdictions will adopt those
recommendations fully. Some
jurisdictions may enact all of the
OECD’s concepts, but others may only
use the more easily administered
rules. Certain jurisdictions have
already put in place their own antihybrid regimes. It is not yet clear if
those jurisdictions will expand their
legislation to include additional
recommendations, such as the
imported mismatch rules, given their
complexity. The jurisdictions with
existing anti-hybrid rules may feel
those rules (and related provisions)
adequately address base erosion from
cross-border payments.
Non-uniform adoption of the OECD
recommendations could result in
double taxation and affect investment
decisions. Companies and other
investors may be unwilling to make
substantial funding commitments in
jurisdictions that apply the hybrid
report’s concepts in a manner likely to
result in double taxation. The Dutch
government, for one, has stated that it
will not unilaterally tighten rules
governing hybrids but will continue to
ensure that the Netherlands remains
attractive for foreign investment.
The final report generally confirms the
concepts and recommendations in the
September 2014 hybrids deliverable,
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Tax Policy Bulletin
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact:
Neutralise the effects of hybrid mismatch arrangements
Justin Woodhouse, St Helier
+44 (0) 1534 838233
[email protected]
Calum Dewar, New York
+1 (646) 471-5254
[email protected]
Peter Collins, Melbourne
+61 (3) 8603 6247
[email protected]
Suchi Lee, New York
+1 (646) 471-5315
[email protected]
Michael Urse, Cleveland
+1 (216) 875-3358
[email protected]
Greg Lubkin, Washington
+1 202-414-1542
[email protected]
Jonathan Hare, London
Neil Edwards, London
+44 (0)20 7804 6772
[email protected]
+44 (0)20 7213 2201
[email protected]
Tax policy
Pam Olson, Washington
+1 (202) 414 1401
[email protected]
Richard Collier, London
+44 (0) 20 7212 3395
[email protected]
Edwin Visser, Amsterdam
+31 (0) 88 7923 611
[email protected]
Phil Greenfield, London
+44 (0) 20 7212 6047
[email protected]
Stef van Weeghel, Amsterdam
+31 (0) 88 7926 763
[email protected]
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