4.3.5.6 Measures to counter hybrid mismatch arrangements

The ATAD2 measures to counter hybrid mismatch arrangements

Hybrid mismatches are the consequence of differences in the legal characterization of payments (financial instruments) or entities that arise as a result of the interaction between the legal systems of two jurisdictions. The effect of such mismatches is often a double deduction (i.e., a deduction of the same expenses in more than one jurisdiction) or a deduction without inclusion (i.e., a deduction of the income in one state without the inclusion of the income in the tax base of the other state). These types of arrangements can easily erode the taxable basis of the countries involved.1 Truly ending the possibility that hybrid mismatches occur would require ending the conflict in characterization. Alternatively, the fiscally advantageous mismatch in tax outcome can be neutralised. The latter solution has been presented by the OECD2 and has been followed in ATAD2.

ATAD1 contains measures to counter hybrid mismatch arrangements in situations where there are differences in the legal characterization of payments or entities between Member States that lead to a double deduction or a deduction without inclusion. ATAD2, which amended ATAD1, counters the hybrid mismatch arrangements due to differences in legal characterizations in situations between Member States and in third country situations (i.e., non-EU Member States). Moreover, ATAD2 introduces more detailed rules to neutralise hybrid mismatches and includes rules that address types of hybrid mismatches that do not fall within the scope of ATAD1, such as hybrids involving permanent establishments, dual resident mismatches, imported mismatches, and reverse hybrids.

The anti-hybrid rules contain primary rules and secondary rules to neutralise the different types of hybrid mismatches. The main rules are as follows:

The anti-hybrid rules are specifically aimed at group situations, as they only apply if there is a sufficient connection between the parties.3 The rules apply to hybrid mismatches that arise between a taxpayer and its associated enterprise or between two associated enterprises.4 Furthermore, the rules apply to hybrid mismatches that apply between a head office and a permanent establishment, or between two or more permanent establishments of the same entity. Additionally, mismatches resulting from a structured arrangement are within the scope of the rules. Depending on the exact implementation the rules could lead to economic double taxation.5

Measures to counter hybrid mismatch arrangements & the OECD MTC

As hybrid mismatches normally occur within group situations, the question arises whether tax treaties adequately deal with hybrid mismatches. The OECD MTC includes a provision specifically for transparent entities.6 This provision ensures that treaty benefits are granted in appropriate cases. In short, treaty benefits are granted only to income of an entity that is considered wholly or partly transparent by either treaty jurisdiction if that income is treated as the income of a resident of that State. The provision for hybrid entities incorporates the principles included in the partnership report in the OECD MTC.7 The provision applies to hybrid entities as well as to hybrid arrangements.8

For the ATAD2 anti-hybrid rules the question is whether those rules authorise for example the denial of deduction that is prescribed to neutralise the hybrid mismatch, whereas the OECD MTC hybrid rule mainly deals with whether or not a person is entitled to treaty benefits such as a lowered withholding tax rate. Tax treaties in principle do not deal with the answer to the question whether or not payments are deductible and whether or not they are effectively taxed. These matters are governed by domestic law. The only provisions in this respect that are relevant in determining whether payments are deductible are art. 7 and art. 24 of the OECD MTC.9 For determining the profits that are attributable to a permanent establishment it is – subject to the non-discrimination provisions for permanent establishments10 – up to the domestic law of the Contracting States to determine the conditions for the deductibility of expenses.11 The tax treaty thus does not deal with the issues of whether expenses are deductible when computing the taxable income of the entity in the treaty states.12 There should thus be no conflict between the primary rule and tax treaties, irrespective of the type of mismatch (e.g., a hybrid financial instrument or a hybrid entity). The non-discrimination provision also does not seem to lead to problems in respect of the application of the anti-hybrid rules, as the fact that likely more non-residents are impacted by the rules in itself does not lead to the conclusion that there is discrimination.13

According to the OECD, the defensive rule that requires the inclusion of a payment in ordinary income should generally not be hindered by a tax treaty that is in accordance with the OECD MTC.14 The rule contemplates the imposition of tax solely in the situation where the recipient of the payment is a resident of that jurisdiction or maintains a permanent establishment there. As the allocative rules of tax treaties generally do not restrict the right to tax in such circumstances, any potential conflict between the anti-hybrid rules and the tax treaty would relate to the rules to eliminate double taxation.15 With respect to hybrid financial instruments, the renumeration derived from these instruments is generally classified as dividends (art. 10 OECD MTC) or interest (art. 11 OECD MTC).16 Irrespective of which article is considered applicable, double taxation would be avoided via art. 23 A, par. 2 or art. 23 B OECD MTC by granting a tax credit.17 There would thus not easily be a conflict between the concurrence of the secondary anti-hybrid rule for financial instruments and double tax treaty law.18 This would be different if the relevant tax treaty would, in contrast to the OECD MTC, provide for, e.g., an unconditional exemption for dividends at the level of the payee.19 Also for mismatches with hybrid entities there could be a conflict between the anti-hybrid rules and tax treaties if the inclusion of a payment in ordinary income would be hindered because the relevant tax treaty provides for an exemption of the foreign income.20

As the deductibility of payments is in principle not covered by the OECD MTC, a rule to counter hybrid mismatch arrangements as referred to in ATAD2 does not fit within the model. However, the tax avoidance opportunities that can follow from hybrid mismatches in an international context are not in line with the goals of the OECD MTC. ATAD2 eliminates the hybrid mismatches but does not tackle the problem at its roots. The qualification mismatch as such is not solved (except for the rules on reverse hybrids). Solving the problem at its roots can be done by introducing an overarching group approach in the international tax domain. In this system the corporate veil would no longer be relevant for taxation purposes. The details of such a system will be discussed further in the following chapters.