Hybrid Mismatches And The OECD Proposal: BEPS Action 2 - Global Tax Update

Hybrid mismatch arrangements can be used to achieve double non-taxation including long-term deferral. The OECD report on Action 2 of the 15 BEPS Actions, titled "Neutralising the Effects of Hybrid Mismatch Arrangements", published in September 2014 (the "Report"), comprises two parts—Part I, which provides recommendations with respect to domestic law provisions, and Part II, which relates to treaty provisions.

The principal targets of the Report are tax mismatches resulting from: (i) arrangements involving tax deductions for expenses (normally interest) with no corresponding taxation of the receipt (deduction/no-inclusion or "D/NI"), or (ii) a tax deduction for the same expense in two or more jurisdictions (double deduction or "DD"). These arrangements typically involve a hybrid entity: opaque (e.g., a company) in one jurisdiction, transparent (e.g., a partnership or branch) in another; or a hybrid instrument—debt in one jurisdiction, equity in another. The Report also considers indirect hybrid mismatches where a mismatch arrangement is imported into a third jurisdiction.

Recommendation

BEPS Action 2 will be implemented based on the extent of the present mismatch. This is determined by comparing the tax treatment of the payment under the laws of each jurisdiction. D/NI mismatches occur where a proportion of payment deductible in one jurisdiction does not correspond to the proportion of ordinary income in another. DD mismatches occur where all or part of a payment is also deductible in another jurisdiction. Whilst differences in payments can give rise to mismatches by way of fluctuating foreign currency, they will not give rise to a D/NI outcome. Unilateral, equitable tax deductions will also fail to produce a mismatch because they are economically closer to a tax exemption. Hybrid mismatch rules should not be applied to entities where tax concerns are not raised. The OECD proposals in the Report are mechanical, and there is no need to show purpose.

Scope

The Report states that the hybrid mismatch rules are designed to:

neutralise mismatches in tax treatments without changing the tax characterisation and commercial outcome of the arrangement or instrument; be comprehensive; apply automatically; avoid double taxation through rule co-ordination; minimise disruption to existing domestic law; be clear and transparent in their operation; provide sufficient flexibility to allow for implementation in each jurisdiction; be workable for taxpayers and keep compliance costs to a minimum; and be easy for tax authorities to administer. The Report also states that jurisdictions should co-operate on measures to ensure recommendations are implemented and applied consistently and effectively. These measures include:

developing agreed guidance on the recommendations; co-ordinating the implementation of the recommendations (including time); developing transitional rules (with no assumed grandfathering of existing arrangements); reviewing the effective and consistent implementation of the recommendations; exchanging information on the jurisdiction as treatment of hybrid financial instruments...

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