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How your business should respond to BEPS Action 2

The report proposes national rules to address hybrid mismatch arrangements and recommends changes to the OECD Model Tax Convention.

On 5 October 2015, the Organisation for Economic Co-operation and Development (OECD) released its final report on hybrid mismatch arrangements under Action 2 of its Action Plan on Base Erosion and Profit Shifting (BEPS).

This report was released in a package that included final reports on all 15 BEPS Actions.

The final report on Action 2, Neutralizing the Effect of Hybrid Mismatch Arrangements (the Final Report), supersedes the interim report that was released in September 2014[i] (the 2014 report).

Similar to the 2014 report, the Final Report consists of two parts with detailed recommendations to address hybrid mismatch arrangements and reflects the consensus achieved on these issues.

  • Part I contains recommendations on domestic law rules to address hybrid mismatch arrangements.
  • Part II contains recommended changes to the OECD Model Tax Convention.

The recommendations in Part I include “specific recommendations” and “hybrid mismatch rules.”

The specific recommendations are modifications to provisions of domestic law aimed at avoiding hybrid mismatches and achieving alignment between those domestic law provisions and their intended tax policy outcomes (e.g., by not applying a dividend exemption at the level of the payee for payments that are deductible at the level of the payer).

The hybrid mismatch rules are linking rules aimed at neutralizing one of the following three mismatches in tax outcomes arising out of certain hybrid mismatch arrangements:

  • Payments that give rise to a deduction with no taxable inclusion arising from a hybrid financial instrument (including a hybrid transfer), a disregarded payment made by a hybrid entity or a payment made to a reverse hybrid
  • Payments that give rise to a double deduction arising from a deductible payment made by a hybrid entity or a dual resident
  • Payments that give rise to an indirect deduction with no inclusion arising from an imported mismatch

The defensive rule

The hybrid mismatch rules are divided into a primary response and, where applicable, a secondary or defensive rule.

The defensive rule applies only where there is no hybrid mismatch rule in the counterparty jurisdiction or where the rule is not applied to the particular entity or arrangement.

Each of the hybrid mismatch rules has its own specified scope of application.

In a significant expansion from the 2014 report, the recommendations in Part I of the Final Report have been supplemented with further guidance and a wide array of detailed examples to explain the operation of the rules.

Some outstanding issues that were identified in the 2014 report are addressed, such as the treatment of stock lending and sale and repurchase transactions, the treatment of non‑interest-bearing loans and the treatment of branch structures within the hybrid mismatch arrangement category for hybrid financial instruments.

In addition, the Final Report includes new and detailed guidance on how to treat a payment that is included under a controlled foreign corporation (CFC) regime.

The imported mismatch rule

Significant new guidance on the operation of the imported mismatch rule is provided as well, which includes three tracing and priority rules to determine the extent to which a payment should be treated as set off against a deduction under an imported mismatch arrangement.

Part II of the Final Report focuses on changes to be made to the OECD Model Tax Convention in addressing Action 2.

It complements Part I and deals with the parts of Action 2 that indicate that the outputs of the work on that action item may include changes to the OECD Model Tax Convention to see that hybrid instruments and entities, as well as dual-resident entities, are not used to obtain the benefits of treaties unduly.

It notes that special attention should be given to the interaction between possible changes to domestic law and the provisions of the OECD Model Tax Convention.

Furthermore, Part II specifically examines treaty issues related to dual-resident entities, includes a proposal for a new treaty provision dealing with transparent entities and addresses the issue of the interaction between the recommendations included in Part I of the Final Report and the provisions of tax treaties.

The Final Report recommends that every jurisdiction introduce all the rules contained in the report and that jurisdictions cooperate on measures so that these rules are implemented and applied consistently and effectively.

Part I: recommendations for domestic law

The recommended hybrid mismatch rules set out in the Final Report are designed to target particular arrangements that give rise to the following outcomes:

  • Payments that give rise to a deduction/no inclusion outcome (D/NI outcome) (i.e., payments that are deductible under the rules of the payer jurisdiction and are not included in the ordinary income of the payee) — Recommendations 1-5 deal with such D/NI outcomes
  • Payments that give rise to a double deduction outcome (DD outcome) (i.e., payments that give rise to two deductions in respect of the same payment) — Recommendations 6 and 7 deal with such DD outcomes
  • Payments that give rise to an indirect D/NI outcome (i.e., payments that are deductible under the rules of the payer jurisdiction and that are set off by the payee against a deduction under a hybrid mismatch arrangement) — Recommendation 8 deals with such indirect D/NI outcomes

Recommendation 1 — hybrid financial instrument rule

The hybrid financial instrument rule under Recommendation 1 applies to three particular types of financing arrangements as follows:

  • Arrangements that are treated as debt, equity or derivative contracts under local law (“financial instruments”)
  • Arrangements involving the transfer of financial instruments where differences in the tax treatment of that arrangement result in the same financial instrument being treated as held by more than one taxpayer (“hybrid transfers”)
  • Arrangements involving the transfer of financial instruments where a payment is made in substitution for the financing or equity return on the transferred asset and differences between the tax treatment of that payment and the underlying return on the instrument have the net effect of undermining the integrity of the hybrid financial instrument rule (“substitute payments”)

With respect to a payment made under a financial instrument that results in a hybrid mismatch and a substitute payment under an arrangement to transfer a financial instrument, the hybrid financial instrument rule recommends as a primary response that the payer jurisdiction deny a deduction for such payment to the extent it gives rise to a D/NI outcome.

If the payer jurisdiction does not neutralize the mismatch, then the payee jurisdiction will require such payment to be included in ordinary income to the extent the payment gives rise to a D/NI outcome.

This is the defensive rule.

Differences in the timing of the recognition of payments will not be treated as giving rise to a D/NI outcome for a payment made under a financial instrument, provided the taxpayer can establish to the satisfaction of a tax authority that the payment will be included as ordinary income within a reasonable period of time.

Furthermore, differences in tax outcomes that are solely attributable to differences in the value ascribed to a payment (including through the application of transfer pricing) do not fall within the scope of the rule.

It is stated that the hybrid financial instrument rule only applies where the mismatch in tax treatment is attributable to the terms of the instrument (e.g., application of different accounting policies to the same instrument) rather than the status of the taxpayer or the context in which the instrument is held.

For example, the hybrid financial instrument rule should not apply to a payment made to a tax-exempt recipient if this tax‑exempt status is the only reason for the D/NI outcome.

Furthermore, it is noted that the scope of the rule would be limited to payments made to related persons and under structured arrangements to which the taxpayer is a party.

These operative terms are defined in Recommendations 10 and 11 of the Final Report.

In terms of exceptions to the rule, in certain circumstances the primary rule should not apply to a payment made by certain entities where the tax policy of the deduction under the laws of the payer jurisdiction is to preserve tax neutrality for the payer and payee.

A number of examples are cited, including the example of a mutual fund or real estate investment trust that has the right, under domestic law, to deduct dividends to preserve its tax neutrality — such deductible dividend payments, it is noted, generally should not give rise to a hybrid mismatch under the hybrid financial instrument rule. It is noted, however, that the defensive rule would continue to apply to any such payment on receipt.

In determining the type of payments targeted under the hybrid financial instrument rule, it is important to note that the definition of “payment” for the purposes of the Final Report specifically excludes payments that are only deemed to be made for tax purposes.

Therefore, the rule would not apply to an adjustment resulting from a deemed interest charge on equity.

In addition, the Final Report includes two specific examples concerning interest-free loan arrangements, showing a difference in treatment for situations in which a borrower — for tax accounting purposes — accrues a deemed discount on an interest-free loan and situations where a borrower claims a (deemed) deduction for tax purposes as if it had paid interest on the loan at a market rate.

The latter arrangement does not fall within the scope of the hybrid financial instrument rule, because there is no payment under the loan that gives rise to a deduction in the borrower’s territory.

The additional detailed analysis set out in the example notes that a deduction that arises in respect of an amount that is not capable of being paid is not considered a “payment” for the purposes of applying the rule. For the arrangement where a borrower splits the loan payable into two separate components for tax accounting purposes (i.e., a loan treated as having been issued at a discount and a deemed equity contribution) and there is an accrual for the deemed discount on the interest-free loan, no deduction should be available to the borrower in relation to the accrual of the deemed discount.

The category of hybrid transfers is a notable addition compared with the 2014 report and is defined as being any arrangement to transfer a financial instrument where, as a consequence of the economics of the transaction and the way it is structured, the laws of two jurisdictions take opposing views on who is the owner of the underlying return on the transferred asset.

The Final Report recommends that jurisdictions treat hybrid transfers as financial instruments within the scope of the hybrid financial instrument rule.

Hybrid transfers include sale and re-purchase (repo) transactions and security lending transactions where the rights and obligations of the parties are structured in such a way that the transferor remains exposed to the financing or equity return on the financial instrument transferred under the arrangement.

A number of detailed examples setting out the application of the hybrid financial instrument rule to such transaction types — particularly with respect to traders — are included in the Final Report.

Also considered in some detail under Recommendation I of the Final Report is the application of the hybrid financial instrument rule in a scenario where certain mechanisms of tax relief such as (partial) exemption, (partial) credit and rate reduction are in play.

In those cases, the amount of the deduction that should be denied should generally be no more than is necessary to eliminate the mismatch in tax outcomes and a deduction should continue to be allowed to the extent the payment is subject to tax in the payee jurisdiction at the full rate.

A number of examples illustrating partial exemption/credit and reduced rate scenarios are included in the Final Report.

A notable area of guidance and commentary with respect to Recommendation 1 includes guidance on the treatment of payments that are included under a CFC regime.

A payment that has been fully attributed to a parent (or the ultimate parent) of the group under a CFC regime and has been subject to tax at the full rate should be treated as having been included in ordinary income for the purposes of the reverse hybrid rule.

In addition to the examples referenced above, a wide number of other detailed examples are also included in the Final Report.

Recommendation 2 — specific recommendations for the tax treatment of financial instruments

This section sets out specific recommendations for changes to the tax treatment of cross-border financial instruments to prevent hybrid mismatches from arising.

First, it is recommended that countries do not grant a dividend exemption or equivalent tax relief for dividend payments that are treated as deductible by the payer.

This recommendation only affects payments that would otherwise qualify for dividend exemption or equivalent tax relief and does not deal with other types of non-inclusion such as a payment that is treated as a return of capital.

Second, to prevent duplication of tax credits under a hybrid transfer, the Final Report recommends limiting the ability of a taxpayer to claim relief from foreign withholding tax on instruments that are held subject to a hybrid transfer.

In effect, under this recommendation, the benefit of any tax credits would be restricted in proportion to the net taxable income of the recipient taxpayer under the arrangement.

Supplementary guidance and a number of detailed examples with respect to the above recommendations are also included in the Final Report.

There is no limitation of scope with regard to the application of Recommendation 2.

Recommendation 3 — disregarded hybrid payments rule

Under the disregarded hybrid payments rule, a number of recommendations deal with the situation where a hybrid payer makes a deductible payment under the laws of the payer jurisdiction that is disregarded under the laws of the payee jurisdiction.

Such a rule could, for example, apply to a holding company (in Country A) that lends to a direct subsidiary (in Country B), where the direct subsidiary is treated as a disregarded (transparent) entity for tax purposes in Country A but is treated as a separate (opaque) entity for tax purposes in Country B.

The primary recommendation under the disregarded hybrid payments rule calls for denying a deduction for such a payment to the extent that it gives rise to a D/NI outcome.

And under the recommended defensive rule, the payee jurisdiction would require such a payment to be included in ordinary income to the extent that the payment gives rise to a D/NI outcome.

The Final Report goes on to note that no mismatch will arise to the extent that the deduction in the payer jurisdiction is set off against income included in ordinary income of both the payer’s and payee’s jurisdictions (i.e., dual-inclusion income) and that any deduction that exceeds the amount of dual-inclusion income may be eligible for set off against dual-inclusion income in another period.

The disregarded hybrid payments rule will only apply when a hybrid payer makes a disregarded payment, and the rule is limited in scope to parties within the same control group (as defined in Recommendation 11) or where the payment is made under a structured arrangement (as defined in Recommendation 10) to which the taxpayer is a party.

Supplementary guidance and a number of detailed examples in relation to the disregarded hybrid payments rule also are included in the Final Report.

Recommendation 4 — reverse hybrid rule

The reverse hybrid rule seeks to address D/NI outcomes arising from payments made to a reverse hybrid. A reverse hybrid is any person that is treated as a separate entity by an investor and as transparent under the laws of the territory in which the person is established.

With respect to a payment made to a reverse hybrid that results in a hybrid mismatch, the reverse hybrid rule recommends that the payer jurisdiction deny a deduction for such payment to the extent that it gives rise to a D/NI outcome. It is further noted that a payment will result in a hybrid mismatch if a mismatch would not have arisen had the accrued income been paid directly to the investor.

In terms of scope, the reverse hybrid rule only applies where the investor, the reverse hybrid and the payer are members of the same control group (as defined in Recommendation 11) or if the payment is made under a structured arrangement (as defined in Recommendation 10) to which the payer is a party.

Supplementary guidance and a number of detailed examples in relation to the reverse hybrid rule are also included in the Final Report.

Recommendation 5 — specific recommendations for the tax treatment of reverse hybrids

This section includes three specific recommendations in relation to the tax treatment of reverse hybrids and recommended improvements that jurisdictions could make to their domestic law to reduce the frequency of hybrid mismatches. As noted, the specific recommendations are not hybrid mismatch rules.

First, it is recommended that jurisdictions introduce or amend their offshore investment or CFC regimes to prevent D/NI outcomes from arising with respect to payments to a reverse hybrid. As part of this recommendation, it is also suggested that jurisdictions consider introducing or making changes to such regimes in relation to imported mismatch arrangements.

Second, it is recommended that domestic tax laws be modified so that a reverse hybrid is treated as a resident taxpayer of the jurisdiction of organization if its income is not taxed in that jurisdiction and the accrued income of the nonresident investor also is not taxed under the laws of the investor jurisdiction.

This recommendation effectively encourages jurisdictions to “turn off” their tax transparency rules where those rules are primarily used to achieve hybrid mismatches.

Third, it is recommended that jurisdictions should introduce improved tax filing and information reporting requirements in relation to tax transparent entities that are established within that jurisdiction.

Such a recommendation should assist taxpayers and tax administrations in making a proper, more informed, determination of the payments that have been attributed to the nonresident investor that holds the reverse hybrid.

Supplementary guidance and commentary in relation to the above recommendations are also included in the Final Report.

Recommendation 6 — deductible hybrid payments rule

The deductible hybrid payments rule under Recommendation 6 applies to a hybrid payer that makes a payment that is deductible under the laws of the payer jurisdiction and that also triggers a duplicate deduction in the parent jurisdiction.

The recommended rules under the deductible hybrid payments rule are for the parent jurisdiction to deny a duplicate deduction for such payment to the extent it gives rise to a DD outcome.

This is the primary response.

The defensive rule, if the parent jurisdiction does not neutralize the mismatch, is for the payer jurisdiction to deny the deduction for such payment to the extent that the payment gives rise to a DD outcome.

No mismatch will arise to the extent that a deduction is set off against income that is included in income under the law of both the parent and payer jurisdictions (i.e., dual-inclusion income).

Furthermore, it is noted that any deduction that exceeds the amount of the dual-inclusion income (i.e., the excess deduction) may be eligible for setoff against dual-inclusion income in another period.

To prevent stranded losses, the excess deduction may be allowed to the extent that the taxpayer can establish, to the satisfaction of the tax administration, that the excess deduction in the other jurisdictions cannot be set off against income of any person under the laws of the other jurisdiction that is not dual-inclusion income.

A person will be treated as a hybrid payer with respect to a payment that is deductible under the laws of the payer jurisdiction where 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 where the payer is resident in the payer jurisdiction and the payment triggers a duplicate deduction for an investor in that payer (or a related person) under the laws of the other jurisdiction (the parent jurisdiction).

The Final Report goes on to state that the deductible hybrid payments rule only applies to a deductible payment made by a hybrid payer and such payment results in a hybrid mismatch.

While there is no limitation on scope in respect of the recommended primary response, the defensive rule only applies if the parties to the mismatch are in the same control group or where the mismatch arises under a structured arrangement and the taxpayer is party to that structured arrangement.

Supplementary guidance and a number of detailed examples in relation to the deductible hybrid payments rule recommendations are also included in the Final Report.

Recommendation 7 — dual-resident payer rule

The dual-resident payer rule under Recommendation 7 applies where the payer is a dual resident and makes a payment that is deductible under the law of both jurisdictions and that DD outcome results in a hybrid mismatch.

The recommended rule under the dual-resident payer rule is for each resident jurisdiction to deny a deduction for such payment to the extent it gives rise to a DD outcome.

Recommendations with respect to dual-inclusion income and stranded losses are similar to those made under Recommendation 6.

The rule only applies to deductible payments made by a dual resident, and that a taxpayer will be a dual resident if it is resident for tax purposes under the laws of two or more jurisdictions.

The dual-resident payer rule will only apply to payments that result in a hybrid mismatch.

A hybrid mismatch will arise where a deduction for a payment may be set off, under the laws of the other jurisdiction, against income that is not dual-inclusion income.

Supplementary guidance and an example in relation to the use of a consolidation regime and the use of a reverse hybrid structure involving a dual-resident entity is also included in the Report.

There is no limitation of scope with regard to the application of the dual-resident payer rule.

Recommendation 8 — imported mismatch rule

This recommendation addresses the so-called imported mismatch arrangements under which the deduction resulted from a hybrid mismatch arrangement that was produced in a different jurisdiction, is imported to a third jurisdiction and set off the income in that third jurisdiction.

The imported mismatch rule disallows deductions for a broad range of payments (including interest, royalties, rents and payments for services) if the income from such payments is set off, directly or indirectly, against a deduction that arises under a hybrid mismatch arrangement in an offshore jurisdiction.

The overriding objective of the imported mismatch rule is to maintain the integrity of the other hybrid mismatch rules by removing any incentive for multinational groups to enter into hybrid mismatch arrangements.

The imported mismatch rule applies to both structured and intra-group imported mismatch arrangements and can be applied to any payment that is directly or indirectly set off against any type of hybrid deduction.

Definition

A hybrid deduction is defined as:

  • A payment under a financial instrument that results in a hybrid mismatch
  • A disregarded payment made by a hybrid payer that results in a hybrid mismatch
  • A payment made to a reverse hybrid that results in a hybrid mismatch

Or

  • A payment made by a hybrid payer or dual resident that triggers a duplicate deduction resulting in a hybrid mismatch

A hybrid deduction also includes a deduction resulting from a payment made to any other person to the extent that person treats the payment as set off against another hybrid deduction.

A notable addition compared with the 2014 report in that the guidance sets out three tracing and priority rules (i.e., the “structured imported mismatch rule,” the “direct imported mismatch rule” and the “indirect imported mismatch rule”) to be used by taxpayers and administrations to determine the extent to which a payment should be treated as set off against a deduction under an imported mismatch arrangement.

Further details and commentary in relation to the three tracing and priority rules above, and the mechanical steps involved in their application, are included in the Final Report.

Guidance on the treatment of payments that are included under a CFC regime is also provided.

As with most of the other rules in Part I of the Final Report, the scope of the imported mismatch rule is limited to taxpayers in the same control group as the parties to the imported mismatch arrangement, or to payments that are made under a structured arrangement to which the taxpayer is a party.

A wide range of detailed examples in addition to supplementary commentary and guidance in relation to the imported mismatch rule also are included in the Final Report.

Recommendation 9 — design principles

This section calls on countries to implement and apply the rules in a coordinated manner that preserves the underlying policy objectives of the Final Report.

This would promote predictability of outcomes for taxpayers and avoid the risk of double taxation.

Recommendation 9.1 addresses certain design principles reiterating that countries should seek to verify that the domestic rules, once implemented, will apply to the same arrangements and entities, and provide for the same tax outcomes, as set out in the Final Report.

The design principles state that for a rule created to address mismatches arising from the use of hybrid arrangements to be effective, it must:

  • Operate to eliminate the mismatch without requiring the jurisdiction applying the rule to establish that it has “lost” tax revenue under the arrangement
  • Be comprehensive
  • Apply automatically
  • Avoid double taxation through rule co-ordination
  • Minimize the disruption to existing domestic law
  • Be clear and transparent in its operation
  • Provide the flexibility necessary for the rule to be incorporated into the laws of each jurisdiction
  • Be workable for taxpayers and keep compliance costs to a minimum
  • Be easy for tax authorities to administer

Recommendation 9.2 sets out further actions that countries should take to see that rules are interpreted and applied consistently on a cross-border basis. More specifically it calls for countries to:

  • Agree on guidance on how the rules ought to be applied
  • Develop standards that will allow coordination of the implementation of the recommendations, including of timing in the application of rules, minimizing impact arising from a different implementation time
  • Identify the need for transitional rules (in this regard the recommendation states that the need for transitional arrangements can be minimized by setting a sufficient notice period for taxpayers and that there will be no presumption as to the need for grandfathering rules)
  • Undertake a review of the operation of the rules as necessary to determine whether they are operating as intended
  • Enter into exchange of information, with early and spontaneous exchange of information recognized as key to an effective implementation of hybrid mismatch rules
  • Endeavor to make relevant information on the tax treatment of entities and financial instruments available to taxpayers
  • Consider — before applying a “fixed ratio rule” under Action 4 — the interaction with other BEPS actions, including providing that rules to address hybrid mismatch arrangements should be applied

Recommendation 9 includes recommendations for domestic law design principles, implementation and coordination that are similar to those in the 2014 report.

Recommendation 10 — definition of structured arrangement

Recommendation 10 includes a general definition of a “structured arrangement” as well as a list of specific examples of structured arrangements.

A structured arrangement is any arrangement where the hybrid mismatch is priced into the terms of the arrangement or the facts and circumstances (including the terms) of the arrangement indicate that it has been designed to produce a hybrid mismatch.

The hybrid mismatch rules apply to any person who is a party to a structured arrangement.

The purpose of the structured arrangement definition is to capture those taxpayers who enter into arrangements that have been designed to produce a mismatch in tax outcomes while keeping taxpayers from having to make adjustments in circumstances where the taxpayer is unaware of the mismatch and derives no benefit from it.

Recommendation 10.3 therefore excludes a taxpayer from the structured arrangement rule where the taxpayer is not a party to the structured arrangement.

The definition of structured arrangement in the Final Report does not significantly deviate from the 2014 report, but the Final Report contains significantly more explanation regarding the definition.

Recommendation 11 — definitions of related persons, control group and acting together

With respect to hybrid financial instruments and hybrid transfers, the scope of the hybrid mismatch rules covers such transactions between related parties.

Other hybrid mismatch arrangements are generally treated as within scope of the recommendations where the parties to the mismatch are members of the same control group.

Two persons will be treated as related if they form part of the same control group or if one person has a 25% investment in the other person or a third person has a 25% investment in both.

Persons who are acting together in respect of the ownership or control of an investment in certain circumstances are required to aggregate their ownership interests for the purposes of the related party test.

In addition, two persons would be in the same “control group” if:

  • They are consolidated for accounting purposes.
  • The first person has an investment in a second person that grants the former effective control, or a third person has such an investment in the first two.
  • The first person has a 50% or greater investment in the second person, or a third person has a 50% or greater investment in both.

Or

  • The two persons can be regarded as associated enterprises under Article 9 of the OECD Model Tax Convention.

A person will be regarded as “holding an investment” if it directly or indirectly holds a percentage of voting rights or value in equity of another person.

The definitions in the Final Report do not significantly deviate from the 2014 report, but the Final Report contains significantly more explanation regarding the definitions.

Recommendation 12 — other definitions

The Final Report notes that the language of the recommendations is not meant to be translated directly into domestic legislation.

Countries are expected to implement these recommendations into domestic law using their own concepts and terminology.

At the same time, the rules in one country need to be coordinated with the rules in other countries. Recommendation 12 therefore includes a wide array of definitions for purposes of the recommendations included in the Final Report, with the aim of consistent application of the rules.

Part II — recommendations on treaty issues

Part II of the Final Report contains recommendations on changes to the OECD Model Tax Convention to be made so that hybrid instruments and entities are not used to obtain treaty benefits inappropriately and to address treaty issues that may arise from the recommended domestic law changes.

Chapter 13 — dual-resident entities

The first recommendation made is with respect to dual-resident entities.

The Final Report makes a reference to new proposed Article 4(3) to the OECD Model Tax Convention as part of the work on Action 6 on treaty abuse.

The proposed article states that the residence of a dual-resident entity should be determined mutually by the competent authorities of the relevant jurisdictions and that in the absence of an agreement, the dual-resident entity cannot claim treaty benefits from any of the jurisdictions involved.

However, the Final Report states that treaty changes alone would not effectively mitigate BEPS concerns associated with dual-resident entities.

Such changes will not, for instance, address avoidance strategies resulting from an entity being a resident of a country under that country’s domestic law while, at the same time, being a resident of another country under a tax treaty concluded by the first country.

This situation may allow an entity to benefit from the advantages applicable to residents under domestic law without being subject to reciprocal obligations (e.g., being able to shift its foreign losses to another resident company under a domestic law group relief system while claiming treaty protection against taxation of its foreign profits).

For these situations, the Final Report suggests changes to domestic law that would deny residency of an entity under domestic law if the entity is treated as resident in another jurisdiction under the applicable income tax treaty.

The Final Report does not reflect significant changes in comparison to the 2014 report.

Chapter 14 — transparent entities

The second recommendation addresses the use of transparent entities to benefit from treaty provisions inappropriately.

In this respect, the Final Report recommends an amendment to Article 1(2) of the OECD Model Tax Convention to include a rule on fiscally transparent entities whereby income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of one of the countries will be considered to be income of a resident only to the extent that the income is treated, for purposes of taxation by that country, as the income of a resident of that country.

Such change would include additions to the Commentary.

The Commentary refers to the principles reflected in the 1999 report of the Committee of Fiscal Affairs that focused on the application of the OECD Model Tax Convention to partnerships (the Partnership Report).

The proposed new Commentary expands the principles in the Partnership Report to other non-corporate entities.

The Final Report does not reflect significant changes in comparison to the 2014 report.

Chapter 15 — interaction between Part I and tax treaties

Part II next comments on the necessity of coordinating with the rules recommended under Part I of the Final Report and how the suggested domestic law changes may affect specific articles of the OECD Model Tax Convention.

With respect to the rule providing for the denial of deductions, the Final Report notes that treaties do not govern whether a payment is deductible.

Such decision is left to the domestic laws and therefore the recommended rule would not infringe any treaty provision.

Furthermore, with respect to the defensive rules that require an inclusion of a payment as ordinary income, the Final Report indicates that such a rule would directly affect the provisions in the OECD Model Tax Convention if such rule sought the imposition of tax on a nonresident whose income would not, under the provisions of any treaty, be taxable in such a country.

However, for all the rules recommended in this Final Report, the term “taxpayer” contemplates the imposition of tax by a jurisdiction only when the recipient is resident of such jurisdiction or has a permanent establishment in it.

Consequently, any interaction between the recommendations and the provisions of tax treaties will relate primarily to the rules concerning the elimination of double taxation.

In this respect, Article 23 A (Exemption Method), as it is worded in the OECD Model Tax Convention, would not create problems for jurisdictions that adopt the recommendations made in Part I of the Final Report, because it specifies that the credit method of Article 23 B (Credit Method) of the OECD Model Tax Convention typically applies to dividends.

What’s the best approach?

However, the Final Report notes that a number of bilateral tax treaties depart from this approach and apply the exemption method with respect to dividends and provides general comments on how to resolve this problem.

The most complete solution suggested is for these countries to consider including rules in their treaties that would allow them to apply the credit method as opposed to the exemption method.

Likewise, Article 23 B is regarded as consistent with the recommendations in Part I of the Final Report.

The only issue noted relates to situations where the parties to a tax treaty either supplement or depart from the basic credit approach of OECD Model Tax Convention Article 23 B.

Finally, the Final Report analyzes the potential application of the anti-discrimination provisions of the OECD Model Tax Convention and concludes that subject to an analysis of the precise wording of the domestic rules that would be drafted to implement the recommendations, the recommendations set out in Part I of the Final Report would not appear to raise concerns about a possible conflict with the provisions of Article 24.



Following the discussion drafts released in March 2014,[i] extensive comments from stakeholders on those discussion drafts and the 2014 report, this Final Report is the conclusive output on Action 2.

The recommendations included in the Final Report incorporate some of the input the OECD received from stakeholders and reflects the consensus reached on those issues.

At this stage, implementation via changes in domestic law and practices and via treaty provisions is at the discretion of individual countries.

The Final Report is an expansive document with complex recommendations.

Considering this complexity and the difficulties countries may face in incorporating these recommendations into their domestic tax system, it remains to be seen to what extent countries will adopt these rules.

However, countries have already begun adopting anti-hybrid measures of various types in advance of the final output on Action 2 from the OECD.

A coordinated approach

In general, OECD countries have agreed to continue to work together on a consistent and coordinated implementation of the BEPS recommendations across all of the Actions.

To further this objective, by early 2016 the OECD and G20 will develop an inclusive framework for monitoring, with all interested countries participating on an equal basis.

Progress on the implementation of Action 2 should be subject to monitoring and further discussions are likely to be needed for consistent implementation by countries.



What is the action trying to achieve?

The objective of BEPS Action 2 is to neutralize hybrid mismatch arrangements that exploit differences in the tax treatment of an entity or financial instrument under the laws of two or more tax jurisdictions.

Because such mismatches may result in multiple deductions for a single expense or deductions without corresponding inclusions, they are considered a tool for BEPS.

The solutions put forward in the Final Report are in the form of best practice recommendations for changes to domestic law and the OECD Model Tax Convention.

The domestic law recommendations are extremely detailed and complex, and their success will depend on a consistent implementation and application by local countries.

Were any of the action recommendations unexpected?

The basic design of the recommendations has not changed considerably from earlier discussion drafts.

Compared with those drafts, the Final Report provides more language on so-called hybrid transfers, including repos and share loans, and also provides a large number of examples which demonstrate how the best practice recommendations are supposed to work.

The proposed rules are structured as so-called linking rules and should be applied in a certain order.

The primary rule is the denial of a deduction for a payment to the extent it is not included in the taxable income of the recipient.

If the primary rule is not applied, then the counterparty jurisdiction can apply a secondary rule, and include the deductible payment in taxable income.

The Final Report also includes an imported mismatch rule, which is designed to capture situations where a payment that does not itself create a hybrid mismatch is made to a hybrid mismatch structure.

Is there any interaction between this action and the others?

There is a close link between Action 2 and the work carried out under other Actions dealing with base erosion, such as Actions 3 (CFC), 4 (interest) and 6 (treaty abuse).

The implementation of some of the recommendations that have come out of different BEPS Actions may in fact mitigate or neutralize the negative impact of hybrid mismatch arrangements.

For instance, the Action 3 Final Report recommends improvements to CFC regimes and other offshore investment regimes that may prevent hybrid mismatches from occurring in respect of payments to certain hybrid entities.

Have any countries made specific comments in relation to this action?

The recommendations are in the form of best practices and will need to be implemented at the local country level.

There is no hard political commitment by local countries to adopt these recommendations, and it should be remembered that many countries already have rules that are aimed at neutralizing hybrid mismatches.

Many countries, for instance, already deny deductions in the case of hybrid arrangements and/or rate arbitrage transactions, and recently a hybrid linking rule was included in the EU Parent-Subsidiary Directive which mandates Member States to deny the participation exemption on deductible payments.[i]

A number of countries like Australia and the UK[ii] have initiated public consultations on whether and how the Action 2 best practice recommendations should be adopted.

Other countries have expressed the view that the recommendations should only be implemented through a coordinated hard law approach, potentially within the EU.

The first half of 2016 (during which the Netherlands holds the EU presidency) will focus heavily on a proposed Anti-Tax Avoidance Directive released by the European Commission on 28 January 2016 that would address the EU-wide implementation of Actions 2 (hybrid mismatches), 3 (CFC rules) and 4 (interest limitation rules), as well as provisions on uniform exit taxation and a switch-over clause as regards a minimum effective corporate taxation rate that were earlier considered as part of the EU Common Consolidated Corporate Tax Base proposal.

The proposed Anti-Tax Avoidance Directive’s hybrid mismatch provisions would apply when two Member States give a different legal characterization to the same taxpayer (hybrid entity), including its permanent establishments in one or more Member State, and this leads to one of two situations:

  • A deduction of the same payment, expenses or losses occurs both in (i) the Member State in which the payment has its source, the expenses are incurred, or the losses are suffered, and (ii) in another Member State
  • A deduction of a payment in the Member State in which the payment has its source without a corresponding inclusion of the same payment in the other Member State

In either case, the legal characterization given to the hybrid entity by the Member State in which the payment has its source, the expenses are incurred or the losses are suffered shall be followed by the other Member State.

Similarly, when two Member States give a different legal characterization to the same payment (hybrid instrument) and this leads to a situation where there is a deduction in the Member State in which the payment has its source without a corresponding inclusion of the same payment in the other Member State, the legal characterization given to the hybrid instrument by the Member State in which the payment has its source shall be followed by the other Member State.

What’s going to happen next, and how uniform might implementation be?

Because of the complexity of the recommended rules and the fact that a large number of countries already have rules that deal with hybrid mismatches, it seems rather unlikely that many countries will implement the recommendations in their entirety.

Instead, countries will likely consider if and how best to integrate the best practice recommendations in their domestic legislative framework, and they will most likely pick and choose those recommendations that best fit their tax policies.

They may also deal with hybrid mismatches in ways not foreseen in the report, such as through the introduction of a subject-to-tax clause, or the introduction of withholding taxes.

Furthermore, a number of countries will likely not want to take the first move in this area, and will wait and see if and how other countries implement the best practice recommendations and then shape their response to such developments.

It should also be noted that structures involving hybrid financial instruments and hybrid entities are most commonly used in the US and Europe, and it is in these regions that legislative changes may be expected.

It seems most likely that a uniform approach to hybrid mismatches will not be achieved and that Action 2 will only increase the patchwork of local anti-hybrid measures.

What are the potential impacts on business?

Companies need to assess to what extent they might be impacted by the best practice recommendations, and will need to monitor the legislative developments on this topic in the countries where they operate.

Companies should also consider how best to migrate out of structures that might be impacted in the future and examine the impact that this may have on their overall financing and treasury strategies.

Finally, companies should also be prepared to participate in local country consultations on this topic, such as the ones that are currently on going in Australia and the UK.



[1]  See EY Global Tax Alert, OECD releases report under BEPS Action 2 on hybrid mismatch arrangements, dated 24 September 2014.

[2] BEPS Action 2: Neutralize the Effects of Hybrid Mismatch Arrangements (Recommendations for Domestic Laws) and BEPS Action 2: Neutralize the Effects of Hybrid Mismatch Arrangements (Treaty Issues), both dated 19 March 2014.

[3] See EY Global Tax Alert, EU formally adopts proposed linking rule for hybrid loans under Parent-Subsidiary Directive, dated 9 July 2014.

[4] See EY Global Tax Alert, UK issues consultation document on implementing OECD proposals on hybrid mismatches, dated 9 December 2014.



This article was first published in EY´s Tax Policy and controversy briefing 17

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