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OECD BEPS – Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements

In this post, I summarize Action 2 of the BEPS package published by OECD in September the aim of which is to neutralize the effects of so-called hybrid mismatch arrangements, referred to hereinafter as “hybrid arrangements”, “hybrid structures” or simply as “hybrids”.


A hybrid arrangement is an arrangement that exploits a difference in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions in order to reduce the aggregate tax burden of the parties to the arrangement or to achieve double non-taxation.

Action 2 is made up of two parts. Part I provides recommendations for the alignment of domestic rules to neutralise the effect of hybrid mismatch arrangements. Part II sets out recommended changes to the OECD Model Tax Convention (“OECD MTC”). The report differentiates between hybrid structures based on whether they involve hybrid entities or hybrid instruments. In the former case, the same entity is treated differently under the laws of two jurisdictions (e.g. in the case of partnerships, which are subject to corporate tax in Hungary but not in Austria, where they are regarded as so-called conduit companies and the persons standing behind the partnerships are taxed). The latter category relates to financial instruments, which are, for instance, treated as interest in one jurisdiction and as dividend in another and are, therefore, exempt from taxation in both states (due to deduction or exemption options).

The consequences of such different (hybrid) treatment can be, for example, multiple deductions for a single expense, deduction in one country without corresponding taxation in another or the generation of multiple foreign tax credits for one amount of foreign tax paid. The purpose of the report is to neutralize these tax disadvantages through the appropriate amendment of domestic tax regulations and the OECD MTC.

Cases of hybrid arrangements

In practice, the most common example is the “hybrid loan” concept, which, in a European relation, means that the amount paid by the subsidiary as an interest of a loan received from the parent company is treated as dividend in the state of the parent company. This hybrid structure leads to double non-taxation since the subsidiary reduces its tax base by the amount as an expense, while, in the state of the parent company (a typical example would be the Netherlands),the income is exempt from taxation as dividend received.

Another example for companies could be the different treatment in each country of the positive valuation differences potentially arising during transformations. In the case of a cross-border merger (e.g. if a foreign company merges into a Hungarian company),assets can be revaluated. If the balance of the revaluation is positive, i.e. the new aggregate book value is higher than the previous book value, the difference generates tax liability (at least in most countries). However, there may be differences between countries as to which of the companies has to pay the tax on this difference during the transformation. Double non-taxation arises if the acquiring company is obliged to pay the tax on the difference under the laws of the state of the acquired company and the acquired company is obliged to pay the tax under the laws of the country of the acquiring company. As the acquired and the acquiring companies are in different states, the revaluation difference will ultimately not be taxed in either of the states as a result of the different rules.

Double non-taxation may arise also if, for example, a domestic resident individual receives income from abroad, which would be taxable under domestic rules but the treaty in place between the two countries gives the right of taxation to the country of the source of the income. If the transaction falls under a different tax treatment and is therefore not taxable in the country of source, it will not be taxed in that country either.

Part I of Action 2 – Recommendations for domestic tax regulation

Part I of the action relates to domestic tax regulations. The report basically intends to introduce/alight domestic rules for the treatment of the following types of transactions:

  • payments under hybrid mismatch arrangements that are deductible under the rules of the payer jurisdiction and do not qualify as income under the rules of the payee jurisdiction (deduction / no inclusion orD/NIoutcomes according to OECD);
  • payments under hybrid mismatch arrangements that give rise to duplicate deductions for the same payment (double deduction orD/Doutcomes according to OECD).

The report’s specific recommendations for the amendment of domestic tax rules are as follows:

  • denial of a dividend exemption in respect of deductible payments made under financial instruments;
  • introduction of measures to prevent hybrid transfers being used to duplicate credits for taxes withheld at source (inclusion / exemption);
  • improvements to controlled foreign company (CFC) regimes to make sure that no income at hybrid entities remains untaxed and prescribing a registration obligation in this regard;
  • introduction of rules restricting the tax transparency of reverse hybrids that are members of a controlled group.

A number of countries have already introduced some of the above listed measures (the first one, above all) in 2014. While the above rules are basically preventive and are designed to prevent hybrid arrangements from arising, the following more general recommendations serve the alignment of tax consequences:

  • denial of deduction for payments that are also deductible in another jurisdiction;
  • prevention of the exemption or non-recognition for payments that are deductible by the payer;
  • denial of deduction for payments that are not includible in ordinary income by the recipient (and is not subject to taxation under CFC or similar rules).

The action divides the measures into two groups (primary response and defensive rules) in order to ensure the neutralization of the effects of hybrid arrangements also if one of the states concerned does not apply the neutralizing rules.

The defensive rule would apply if the primary response could not be applied. In the above mentioned D/NI cases, for instance, the primary response would be the denial of deduction at the payer while the defensive rule would be the reclassification of the income at the payee. In D/D cases, deduction would be denied at the parent company as the primary response and at the payer as the defensive rule.

Part II – Recommendations for treaty issues

Part II of Action 2 is basically a supplementation of Chapter 1 and examines the following 3 aspects from the perspective of the OECD MTC:

  • The action reflects on the expected amendment to one of the rules for determining residence in the OECD MTC (Article 4, paragraph (3)) with the aim to make sure that dual-resident entities may not apply benefits illegitimately (this matter is addressed comprehensively in Action 6 of BEPS).
  • It urges the amendment of the OECD MTC for a treatment of conduit companies that is more efficient and effective from a tax perspective.
  • Finally, the action examines the interactions between the recommendations in Part I and the provisions of the OECD MTC.

Next steps

Similarly to the previously discussed Action 5 of BEPS, Action 2 is also published in transitional form for now and will be finalized in September 2015. The final material will contain a Commentary including practical explanations and examples as well.

The conclusions of the Actions 3 and 4 will also have to be considered during the finalization of this action. (These reports have not yet been published even in transitional forms).

A few examples for the measures already taken

In my post of 9 July 2014 I already mentioned that the European Commission already put forward an amendment proposal for the Parent-Subsidiary Directive in the end of last year in order to eliminate hybrid financing, which was accepted on 8 July 2014. Now the directive only exempts the dividend received by the parent company if it is not deductible in the member state of the subsidiary and the directive also expressly provides for taxation in the member state of the parent company if the amount paid is deductible from the corporate tax base of the subsidiary. Member states must integrate the amendment of the directive in their national tax rules until 31 December 2015.

This April, a domestic guideline proposal was accepted in France specifically serving the neutralization of the effects of hybrid arrangements. The final guideline was published on 5 August. It provides (among others) that interest expenditure is deductible if the French entity paying the interest proves that the foreign provider of the loan pays corporate tax on the interest income of a rate equivalent at least to the French corporate tax rate of 25%.

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