BEPS Action Plan 2: Neutralizing the effects of hybrid mismatch arrangements
Hybrid mismatch arrangements are the focus of the 2-part Action Plan 2 of the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) initiative. Hybrid Mismatch Arrangements abuse differences in the tax treatment of an instrument (i.e., a hybrid instrument) or an entity (i.e., a hybrid entity) by separate jurisdictions to reduce or eliminate taxes. Action Plan 2 contains recommendations for changes (i) to domestic tax rules of taxing jurisdictions, and (ii) to the OECD Model Tax Convention, to neutralize the effects of hybrid mismatch arrangements. Part I of Action Plan 2 provides guidance on how countries should implement and apply the recommended rules, and emphasizes that the rules were designed to neutralize mismatches and not simply to minimize tax benefits. The rules should be comprehensive, apply automatically and consistently, avoid double taxation via rule coordination, and minimize disruptions to existing laws. In addition, they should be clear and transparent in their application; provide for flexibility as these are incorporated into each jurisdiction; be workable for taxpayers and entail minimum compliance costs; and minimize administrative burdens on tax authorities.
HYBRID FINANCIAL INSTRUMENT RULE
This rule aims to guard against arrangements resulting in a Deductible and Not Included (D/NI) outcome. This happens when the income payment is reported as a deductible expense of the income payor, but not included in the ordinary income of the income payee or any related investor of the payee. The report recommends that the payor jurisdiction should, as a primary response, deny a deduction for a payment under a financial instrument to the extent that it gives rise to a D/NI outcome. Failing such denial, the payee jurisdiction should require such payment to be included in the payee’s ordinary income. This rule only applies to a payment made to a related person, or where the payment is made under a structured arrangement and the taxpayer is a party to such structured arrangement. A structured arrangement is one where the hybrid mismatch is priced into the terms of the arrangement or is one where the transaction is designed to produce a hybrid mismatch. A taxpayer will not be treated as a party to a structured arrangement if it is unaware of the mismatch and derives no benefit from it.
DIVIDEND EXEMPTION RULE
The report recommends that dividend exemption not be granted to payments that are treated as deductible by the income payor. It also recommends that if a payee jurisdiction grants relief for taxes withheld at source on payments made under a hybrid transfer, such relief should be limited in proportion to the net taxable income of the taxpayer under the arrangement.
DISREGARDED HYBRID PAYMENTS RULE
This rule applies to disregarded payments made by a hybrid payor which results in a hybrid mismatch. A disregarded payment is one that is not taxed in the jurisdiction of the income payee. Payor jurisdictions should deny a deduction for the payment to the extent that it gives rise to a D/NI outcome. If the payor jurisdiction does not do so, the payee jurisdiction should require such payment to be included in the ordinary income of the payee. However, there will be no mismatch to the extent that the deduction in the payor jurisdiction is offset against income that is included in the income of both the payee and the payor. This is called dual-inclusion income. This disregarded payments rule will apply only when the parties to the mismatch belong to the same control group, and if the payment is made under a structured arrangement, with the taxpayer being a party to such structured arrangement.
REVERSE HYBRID RULE
This rule aims to prevent a D/NI outcome of payments to a reverse hybrid. A reverse hybrid is an entity which is treated as a separate entity by a related investor but is considered as a transparent entity in the establishment jurisdiction. Payor jurisdictions are advised to deny a deduction for payments to a reverse hybrid to the extent that it gives rise to a D/NI outcome. This rule will apply when the investor, reverse hybrid, and the payor are part of the same control group and if the payment is made under a structured arrangement, with the taxpayer being a party to such structured arrangement.
Specific recommendations for the tax treatment of reverse hybrids include the following:
CFC AND OFFSHORE INVESTMENT RULES
The report recommends that jurisdictions issue or amend their controlled foreign corporation (CFC) and offshore investment rules to block D/NI outcomes for payments to reverse hybrids. It also recommends that jurisdictions take safeguards against imported mismatch arrangements. For example, it recommends the modification of domestic laws such that a reverse hybrid is treated as a resident taxpayer of the establishment jurisdiction in the event that:
1. The income of the reverse hybrid is not taxed in that jurisdiction, and
2. The accrued income of the nonresident investor is not taxed in the investor jurisdiction.
This will limit tax transparency for nonresident investors. Jurisdictions are also advised to introduce adequate tax filing and information reporting requirements for tax transparent entities.
IMPORTED MISMATCH RULE
Imported mismatch arrangements are those where the deduction resulting from a hybrid mismatch arrangement produced in another jurisdiction is imported into a third jurisdiction and set-off against income in that third jurisdiction. Under this rule, the payor jurisdiction should deny a deduction for any imported mismatch payment to the extent that the payee sets off such payment against a hybrid deduction in the payee jurisdiction. This rule will apply if the taxpayer belongs to the same control group as the parties to the imported mismatch arrangement, or when the payment is made under a structured arrangement to which the taxpayer is a party.
DEDUCTIBLE HYBRID PAYMENTS RULE
This rule aims to prevent a Double Deduction (DD) outcome, where a payment is treated as a deductible expense in more than one taxing jurisdiction. The report recommends that parent jurisdictions should deny a duplicate deduction for an income payment to the extent that it gives rise to a DD outcome. If the parent jurisdiction does not neutralize the mismatch, the defensive rule is that the payor jurisdiction should deny the deduction. This defensive rule applies only when the parties to the mismatch belong to the same control group or when the mismatch arises under a structured arrangement and the taxpayer is a party to such a structured arrangement.
DUAL-RESIDENT PAYER RULE
This will apply to a dual resident, or an entity which is a tax resident of two jurisdictions, which makes a payment that is deductible under the laws of both jurisdictions. Both jurisdictions are advised to deny a deduction for such payment to the extent that it gives rise to a DD outcome.
Part II of Action Plan 2 recommends changes to the OECD Model Tax Convention to thwart the effects of hybrid mismatch arrangements. It references a new version of Article 4 (3) of the OECD Model Tax Convention, in that cases of dual resident entities, or entities which are tax residents of both states to a treaty, shall be solved on a case-to-case basis. It also recommends amending Article 1 (2) of the OECD Model Tax Convention, as well as its commentaries, to include a rule on fiscally transparent entities to ensure that treaty benefits are not granted where neither contracting state taxes the income of the entity. Part II also discusses the interaction between the recommendations in Part I regarding changes in domestic legislation, and its effects on tax treaties.
Addressing the BEPS effect of hybrid mismatch arrangements involves numerous steps. The first involves filtering through all the recommendations and deciding what recommendations are applicable in the local setting, and what elements are to be adopted or modified. The second is actually making changes to domestic legislation which is a complex process in itself, which highlights the need to study and consider urgent legislative actions.