On 21 February 2017, the Economic and Financial Affairs Council of the European Union (ECOFIN or the Council) agreed on amendments to the Anti-Tax Avoidance Directive (ATAD)1 to provide for minimum standards for hybrid mismatches involving third countries (i.e., non-European Union (EU) countries) (ATAD 2). The ATAD 2 is one of a package of corporate taxation proposals presented by the Commission in October 2016.2
The ATAD agreed to in June 20163 provides for a broad scope of minimum standards against tax avoidance, but as far as it concerns hybrid mismatches it was limited to hybrid instruments and hybrid entity mismatches between EU Member States. The now agreed amendments to the ATAD expands these minimum standards to hybrid mismatches involving third countries. In addition, the scope is expanded to hybrid permanent establishment (PE) mismatches, hybrid transfers, imported mismatches, reverse hybrid mismatches and dual resident mismatches that were not addressed by the ATAD. ATAD 2 requires Member States to either deny deduction of payments, expenses or losses or include payments as taxable income, in case of such hybrid mismatches.
The Council will adopt the ATAD 2 once the European Parliament has given its opinion. The ATAD 2 needs to be implemented in the EU Member States’ national laws and regulations by 31 December 2019 and will have to apply as of 1 January 2020, except for the provision on reverse hybrid mismatches for which implementation can be postponed to 31 December 2021 and will have to apply as of 1 January 2022.
The ATAD agreed to in June 2016 and applicable as of 1 January 2019, provides, among other things, for a framework to neutralize hybrid mismatch arrangements that arise in the interaction between corporate tax systems of EU Member States. On 12 July 2016, the Council stated its aim to agree on rules by the end of 2016 to cover hybrid mismatches involving third countries, consistent with and no less effective than the rules recommended by the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) report on Neutralising the Effects of Hybrid Mismatch Arrangements (Action 2).4
On 25 October 2016, the European Commission released its proposal for a tax reform across the EU, including the draft ATAD 2, to address third country hybrid mismatches with a proposed application date of 1 January 2019, i.e., the same date as applicable to the intra-EU hybrid mismatch rules under ATAD.5 On 6 December 2016, the Council achieved broad consensus on the ATAD 2 proposal, leaving two issues to resolve: (i) rules that would allow Member States to apply limited exemptions regarding the treatment of hybrid regulatory capital and financial traders; and (ii) the date of implementation.6 Building on the outcome reached under the Slovak Presidency, the Maltese Presidency of the Council of the European Union (Presidency) proposed new wording that allows Member States to apply certain limited exemptions and proposed postponement of the implementation date to 1 January 2020.
During the ECOFIN meeting held on 21 February 2017, the Presidency’s compromise on the ATAD 2 proposal was agreed by the Council.
Scope of the ATAD 2
With the ATAD 2, the European Commission seeks to establish minimum rules that neutralize hybrid mismatches, where at least one of the parties involved is a corporate taxpayer in an EU Member State. In addition to expanding the territorial scope of the ATAD to third countries, the ATAD 2 also expands the scope to address hybrid PE mismatches, hybrid transfers, imported mismatches, reverse hybrid mismatches and dual resident mismatches.
The ATAD 2 would only apply in the case of a hybrid mismatch between “associated enterprises,” between the head office and PE, between two or more PEs of the same entity or under a “structured arrangement.”
The definition of associated enterprise in the ATAD 2 is based on the Action 2 definition of “control group.” An associated enterprise “also means an entity that is part of the same consolidated group for financial accounting purposes as the taxpayer, an enterprise in which the taxpayer has a significant influence in the management or an enterprise that has a significant influence in the management of the taxpayer.”7 Mismatches that particularly pertain to the hybridity of entities (as opposed to hybrid financial instruments) are addressed only where one of the associated enterprises has – at a minimum – effective control over the other associated enterprises. As such, where the mismatch outcome involves a hybrid entity, “…the definition of associated enterprise is modified so that the 25 percent requirement is replaced by a 50 percent requirement.”
A structured arrangement is defined as “an arrangement involving a hybrid mismatch where the mismatch is priced into the terms of the arrangement or an arrangement that has been designed to produce a hybrid mismatch outcome, unless the taxpayer or an associated enterprise could not reasonably have been expected to be aware of the hybrid mismatch and did not share in the value of the tax benefit resulting from the hybrid mismatch.”8
As the ATAD 2 is in response the OECD BEPS conclusions outlined in the Action 2 report, and prescribes Member States to implement the ATAD 2 in their domestic laws and regulations, the ATAD 2 explicitly states that Member States should use the applicable explanations and examples outlined in the Action 2 report as a source of illustration or interpretation to the extent that they are consistent with the provisions of the ATAD 2 and EU Law.
The ATAD 2 describes what constitutes a hybrid mismatch (see below) and will only apply to the extent such mismatch gives rises to a so-called mismatch outcome, i.e., double deductions and deductions without inclusion. Mismatch outcomes that do not result from ”hybridity” (e.g., due to no or limited taxation at the level of the recipient) do not fall in scope of the ATAD 2. In addition, differences in tax outcomes that are solely attributable to differences in the value ascribed to a payment, including through the application of transfer pricing, should not fall within the scope of a hybrid mismatch. Furthermore, the preamble describes that jurisdictions may use different tax periods and have different rules for recognizing when items of income or expenditures have been derived or incurred, and explains that these timing differences should generally not be treated as giving rise to mismatch outcomes.
Types of hybrid mismatches in scope of ATAD 2
(i) Article 9 of the ATAD 2 addresses the following hybrid mismatch arrangements:
- Hybrid entity mismatches: Situations where an entity is qualified as non-transparent under the laws of one jurisdiction and qualified as transparent by another jurisdiction. This includes qualification of an entity under entity classification election regulations (e.g., check-the-box rules).
- Hybrid financial instrument mismatches: Situations where the tax treatment of a financial instrument differs between two jurisdictions.
- Hybrid transfers: Situations where the laws of two jurisdictions differ on whether the transferor or the transferee of a financial instrument has the ownership of the payments on the underlying asset.
- Hybrid permanent establishment mismatches: Situations where the business activities in a jurisdiction are treated as being carried on through a PE by one jurisdiction while those activities are not treated as being carried on through a PE in the other jurisdiction.
- Imported mismatches: Situations where the effect of a hybrid mismatch between parties in third countries is shifted into the jurisdiction of a Member State through the use of a non-hybrid instrument thereby undermining the effectiveness of the rules that neutralize hybrid mismatches. This includes a deductible payment in a Member State under a non-hybrid instrument that is used to fund expenditure involving a hybrid mismatch.
(ii) Article 9a of the ATAD 2 addresses reverse hybrid mismatches. A reverse hybrid mismatch exists where an entity is incorporated or established in a Member State that qualifies the entity as transparent and held by an associated nonresident entity that is located in a jurisdiction that qualifies the entity as non-transparent.9
(iii) Article 9b of ATAD 2 addresses dual resident mismatches. A dual resident mismatch exists when the taxpayer is resident for tax purposes in two jurisdictions.
Treatment of mismatch outcome
The ATAD 2 only provides for rules for certain types of hybrid mismatches (as outlined above) which result in so-called mismatch outcomes; i.e., double deductions, deduction without inclusion, non-taxation without inclusion and double tax credit. In such cases, Member States are either required to deny the deduction of payments, expenses or losses or include payments as taxable income.
Any adjustment that is required to be made under the ATAD 2 should in principle not affect the allocation of taxing rights between jurisdictions set under a double taxation treaty.
Double deduction means a deduction of the same payment, expenses or losses in the jurisdiction in which the payment has its source, the expenses are incurred or the losses are suffered (payer jurisdiction) and in another jurisdiction (investor jurisdiction). In the case of a payment by a hybrid entity or PE, the payer jurisdiction is the jurisdiction where the hybrid entity or PE is established or situated. To the extent that a hybrid mismatch results in a double deduction, the deduction shall be denied in the Member State that is the investor jurisdiction. Where the deduction is not denied by the investor jurisdiction, the deduction shall be denied in the Member State that is the payer jurisdiction.
Deduction without inclusion
Deduction without inclusion means the deduction of a payment (or deemed payment between a head office and its PE or between two or more PEs) in any jurisdiction (payer jurisdiction) without a corresponding inclusion for tax purposes of that payment in another jurisdiction (payee jurisdiction).
Where a hybrid mismatch involves disregarded PE income which is not subject to tax in the Member State in which the taxpayer is resident for tax purposes, that Member State shall require the taxpayer to include the income that would otherwise be attributed to the disregarded PE. This provision applies unless the Member State is required to exempt the income under a double taxation treaty entered into by the Member State with a third country.
To the extent that a hybrid mismatch results in such deduction without inclusion, the deduction shall be denied in the Member State that is the payer jurisdiction. Where the deduction is not denied by the payer jurisdiction (e.g., because it has its source in a third country), the payment shall be included in the income in the Member State that is the payee jurisdiction. However, Member States may elect to exclude this mandatory income inclusion in certain cases regarding differences in allocation of payments to a hybrid entity or between the head office and PE, payments to a disregarded PE and deemed payments between the head office and PE.
A Member State shall deny a deduction for any payment by a taxpayer to the extent that such payment directly or indirectly funds deductible expenditure giving rise to a hybrid mismatch through a transaction between associated enterprises or entered into as part of a structured arrangement. This rule should not apply to the extent that one of the jurisdictions involved in the transaction has made an equivalent adjustment in respect of such hybrid mismatch.
As the ATAD 2 also includes indirect expenditures via the imported mismatch provision, the scope is broad and may also apply to indirect mismatches.
Double Tax Credit
To the extent that a hybrid transfer is designed to produce a relief for tax withheld at source on a payment derived from a transferred financial instrument to more than one of the parties involved, the Member State of the taxpayer shall limit the benefit of such relief in proportion to the net taxable income regarding such payment.
Reverse hybrid mismatches (article 9a)
Although not included in OECD’s BEPS Action 2, the ATAD 2 requires Member States to include rules for taxation of reverse hybrid entities, even if there is no hybrid mismatch situation. Member States in which such reverse hybrid entity is incorporated or established and which regards the entity as a transparent entity, shall regard the entity as a resident of that Member State and tax the entity on its income to the extent that this income is not otherwise taxed under the laws of the Member State or any other jurisdiction.
Tax residency mismatches (article 9b)
To the extent that a deduction for payment, expenses or losses of a taxpayer which is resident for tax purposes in two or more jurisdictions is deductible from the taxable base in both jurisdictions, the Member State of the taxpayer shall deny the deduction to the extent that the other jurisdiction allows the duplicate deduction to be set-off against income that is not dual-inclusion income.
Limitation of the scope
Although the main rule is that Member States are required to deny deductions, expenses or losses or include payments in the taxable income in the case of above described hybrid mismatch situations, the ATAD 2 provides certain (optional) limitations of the scope.
In specific situations, payments made by financial traders do not give rise to hybrid mismatches provided that certain requirements are met. As such, the anti-hybrid mismatch rules regarding double deduction shall not be applicable where a payment is made by a financial trader under an on-market hybrid transfer provided that the payer jurisdiction requires the financial trader to include as income all amounts received in relation to the transferred financial instruments.
Furthermore, ATAD 2 allows Members States to exclude mandatory income inclusion in the case of certain hybrid mismatch situations (e.g., differences in allocation of payments to a hybrid entity or between the head office and PE, payments to a disregarded PE and deemed payments between the head office and PE) that result in a deduction without inclusion, in case the payment has its source in a third country.
In addition, the ATAD 2 includes an exemption for loss absorbing capacity requirements in order to prevent potentially unfair situations between domestically owned and not domestically owned groups. The provision is targeted to the banking sector and the net tax result of applying the exclusion should be the same as it would have been, had the banking subsidiary been able to issue subordinated debt directly to the market. As such, the anti-hybrid mismatch rules regarding deduction without inclusion shall not be applicable to a hybrid financial instrument if it is not part of a structured arrangement and certain other requirements are met. The provision may be applied by Member States until 31 December 2022 and shall be evaluated by the European Commission by 1 January 2022.
The Council will formally adopt the ATAD 2 once the European Parliament has given its opinion. Member States will then have to implement the ATAD 2 in their national laws and regulations by 31 December 2019 and the provisions will have to apply as of 1 January 2020, except for the rules on reverse hybrid mismatches that will have to be implemented by 31 December 2021 and will have to apply as of 1 January 2022.
The European Commission shall evaluate the implementation of the anti-hybrid mismatch rules (and limitations) by 1 January 2022 and will report to the Council thereon.
The ATAD was an unprecedented change in European direct taxation and it will have a significant effect on the taxation of multinational companies operating in the EU. This ATAD 2 completes the picture by tackling mismatches with third countries and significantly expanding the scope of the ATAD to hybrid PE mismatches, hybrid transfers, imported mismatches, reverse hybrid mismatches and dual resident mismatches that may have far reaching consequences for taxpayers operating in the EU.
1. Directive (EU) 2016/1164.
2. See EY Global Tax Alert, European Commission proposes staged approach towards harmonized group tax base, dated 26 October 2016.
3. See EY Global Tax Alert, ECOFIN reaches political agreement on Anti-Tax Avoidance Directive, dated 21 June 2016.
4. See EY Global Tax Alert, OECD releases final report on Hybrid Mismatch Arrangement under Action 2, dated 11 October 2015.
5. See EY Global Tax Alert, European Commission releases draft directive addressing hybrid mismatches with non-EU countries, dated 26 October 2016.
6. See EY Global Tax Alert, European Council achieves broad consensus on draft directive aimed at closing down hybrid mismatches with third country tax systems, dated 7 December 2016.
7. Article 2, point 4, last subparagraph of ATAD 2.
8. Article 2, point 11 of ATAD 2.
9. This provision shall not apply to a collective investment vehicle, i.e., an investment fund or vehicle that is widely-held, holds a diversified portfolio of securities and is subject to investor-protection regulation in the country in which it is established.
EYG no. 00742-171Gbl