BEPS Action 2
Hybrid mismatch arrangements is a rather common practice to seek and use differences in the tax treatment of an entity or instrument in two or more tax jurisdictions to achieve double non-taxation, including long-term deferral. A hybrid mismatch arises when the tax treatment of the payments under a hybrid financial instrument or payment to or from a hybrid entity differ across tax jurisdictions.
An example. Country A treats a loan payment as interest whereas Country B treats the same receipt as dividend. If the interest in Country A is tax deductible and at the same time the dividend is tax exempt in Country B we observe a hybrid mismatch as in the definition of BEPS Action 2.
Generally mismatches can arise if…
- in one tax jurisdiction a deduction is allowed while in the other the income is not taxed;
- in both jurisdictions a deduction is allowed and in only one jurisdiction income is taxed.
For determining a mismatch only those payments that rely on a hybrid element such as a hybrid financial instruments or hybrid entity are in scope. The structure itself is not of concern tax-wise. Note that the value of a payment is not part of the determination of a mismatch as well.
A payment is defined as any transfer of value and includes an amount that is capable of being paid such as a future or contingent obligation to make a payment.
Any financial instrument is marked hybrid when a payment under it gives rise to a mismatch in tax outcomes and the mismatch can be attributed to the terms of the instrument. This is an approach with which all financial instruments are being brought in scope. The nature of the payment and the terms of the instrument are determining the hybrid character.
A hybrid entity is an entity that has a different tax status in two tax jurisdictions leading to a differing tax treatment on payments to or from these kind of entities.
Hybrid arrangements can exist only due to the existence of differences in tax treatments in various jurisdictions and mismatches in tax treaties. The BEPS project aims to resolve these differences.
The BEPS project called for recommendations regarding the design of domestic rules and the development of model treaty provisions that would neutralize the tax effects of hybrid mismatch arrangements. BEPS Action 2 makes recommendations to address the mismatches. The recommendations are split into two parts.
Part 1 makes recommendations for changes to domestic law and Part 2 recommends changes to the OECD Model Tax Convention. Both parts combined aim to put an end to multiple deductions for a single expense, deductions without corresponding taxation or the generation of multiple foreign tax credits for one amount of foreign tax paid.
The first part makes recommendations to domestic law. In total 12 recommendations are made in this part. In essence there are rules, definitions and specific recommendations provided in part 1 of Action 2.
- Hybrid Financial Instrument Rule
- Specific recommendations for the tax treatment of financial instruments
- Disregarded hybrid payments rule
- Reverse hybrid rule
- Specific recommendations for the tax treatment of reverse hybrids
- Deductible hybrid payments rule
- Dual-resident payer rule
- Imported mismatch rule
- Design principles
- Definition of structure arrangement
- Definitions of related persons, control group and acting together
- Other definitions
The recommendations provide a rule set that is aimed at addressing mismatches when they arise in respect of payments made under a hybrid financial instrument or payments made to or from a hybrid entity. A hierarchy in the form of a rule order has been setup. The rule set consists of a primary and a secondary (or defensive) rule.
The rules are applied on three identified tax policy outcomes: Deduction / No Income, Double Deduction, and Indirect Deduction / No Income. A short description of each follows.
Deduction / No Inclusion
Country A treats the payment as deduction whereas the receipt in Country B is not included in ordinary income.
Country A treats the payment as deduction whereas the receipt in Country B can also be deducted.
Indirect Deduction / No Inclusion
Country A treats the payment as deduction and in Country B the receipt is set-off against a deduction under a hybrid mismatch arrangement.
These three mismatches are the basis for the rule setting as recommended in BEPS Action 2. The below table provides an overview of the mismatch, the arrangements in scope, specific recommendations for domestic law changes and the recommended hybrid mismatch rules.
The BEPS project has recognized that the implementation and application of these rules require coordination. It also acknowledges that this is important as not to increase compliance and administration costs for taxpayers and tax administrations.
Part 2 is complementing Part 1. Part 2 handles issues with regards to tax treaties and proposes changes to the OECD Model Tax Convention. Much of the work in this area is already done in BEPS Action 6 – Preventing Treaty Abuse, which concludes that dual residence is to be solved case-by-case. However there are two issues that are included as part of the work on neutralizing hybrid mismatches. These issues are related to dual resident entities and transparent entities in conjunction with tax treaties where tax benefits of treaties are granted in absence of taxation in that jurisdiction.
An entity can have dual residence which means that for tax purposes the same entity (or arrangement) is considered a residence of multiple jurisdictions.
With regards to dual residence it is recommended to jurisdictions to include in their domestic law that an entity that is considered to be a resident of another state under a tax treaty will be deemed not to be a resident under domestic law. With this addition to domestic law the dual residence is reduced to a single residence. The result is that, due to not being a tax resident, tax benefits can also not be granted to the entity.
It is observed that if there is a dual consolidation structure in place where there is no tax treaty between the two jurisdictions that a solution needs to be found in domestic law. Or the two jurisdictions should agree on a tax treaty.
A transparent entity is an entity or arrangement for which the income is not taxed at the entity or arrangement level but at the level of the persons holding an interest in that entity or arrangement. Income derived by or through an entity or arrangement covers any income regardless of who derives that income and regardless of the legal state of the entity or arrangement. In this sense a transparent entity passes through its full income to each of the persons based on the share of holding an interest in the entity.
The Model Tax Convention has been amended to ensure that income of transparent entities is treated in accordance with the already existing principles of the Partnership report. This is an addition to also include transparent entities besides partnerships.
The principles that apply are that tax benefits are not granted where neither jurisdiction treats the income of the entity as the income of one its residents. Establishing a transparent entity in a jurisdiction to obtain tax benefits without having one or more persons holding an interest in that entity in the same jurisdiction is prevented under these principles.
2017 Update – Neutralising the Effects of Branch Mismatch Arrangements
In addition to the original work on Action 2 released in 2015 the OECD has released recommendations on neutralizing the effects of branch mismatch arrangements. Branch and head office mismatch arrangements are targeted in the same manner as in the original recommendations targeted at hybrid mismatch arrangements.
A branch mismatch differs from a hybrid mismatch. A hybrid mismatch results from conflicts in the legal treatment of entities or instruments. A branch mismatch results from differences in the way the branch and head office account for payments made by or to a branch. This is basically a difference based on (tax) accounting treatment.
Branch mismatch arrangements were not in scope in the recommendation made in the 2015 release. In this addition in 2017 the branch mismatch arrangements are included in scope.
Effects of BEPS Action 2
Even if not all jurisdictions are implementing the recommendations of Action 2 the BEPS project has achieved that those jurisdictions that do implement them are effectively neutralizing hybrid and branch mismatch arrangements. As such there is an incentive for jurisdictions to take over the recommendations.
For taxpayers this means that the use of hybrid instruments and entities or the setup of branch structures for pure tax reasons will no longer be economically and commercially viable once enough jurisdictions implement the recommendations of BEPS Action 2.