23 November 2015
The OECD on 5 October 2015 issued its 458-page final report on ‘hybrid mismatch arrangements’ from the base erosion and profit shifting (BEPS) project. The final report generally confirms the concepts and recommendations in the September 2014 hybrids deliverable, along with many examples that make up almost two-thirds of the report’s length. The domestic law recommendations create significant complexity, particularly with respect to ‘imported mismatches.’ The report’s treaty recommendations still have relatively limited scope.
The domestic law recommendations would apply to ‘payments’ from hybrid mismatch arrangements, but not to deemed payments such as notional interest deductions. The report retains the principle of automatic application for the rules, with no subjective motive or purpose test. The structure of primary and defensive linked rules, with a hierarchy, has also been preserved. Generally, the recommendations would require either payer jurisdictions to deny deductions for hybrid mismatch payments or payee jurisdictions to include such payments as income. Some limited new exceptions have been added. The report also provides enhanced guidance on both implementation of the rules and transitional arrangements. These cover the complex situations that may arise in the appropriate counteraction measures, depending on the arrangement and its effect.
It is unclear how widely the complex domestic law recommendations on hybrid mismatches will be adopted. Some jurisdictions may enact all of the OECD’s concepts, but others may only use the rules that are more easily administered. Unfortunately, non-uniform adoption could result in double taxation and may impact investment decisions. Companies and other investors may hesitate to locate profitable operations or make other substantial funding commitments in jurisdictions that apply these concepts in a manner likely to result in double taxation. It appears unlikely that most jurisdictions will coordinate to adopt these OECD recommendations in a genuinely multilateral manner. The Dutch government has already stated that it will not unilaterally tighten regulations with respect to hybrids and will continue to ensure that the Netherlands remains attractive for foreign investment.
The main features of the final hybrids report, including significant changes from the previous deliverable, are set out below. www.pwc.com

Tax Policy Bulletin
Composition of the report
In Part I, the OECD recommendations for domestic laws to address hybrids are identified and categorised within three types of hybrid mismatch arrangements, which are identified according to their tax effects.
Chapters 1-8 include the recommendations for specific types of hybrid mismatches. Chapter 9 addresses design principles for these recommendations, as well as implementation and transition arrangements. Chapters 10-12 provide certain key definitions.
Unless otherwise noted, all definitions provided are contained in Chapter 12.
Hybrid mismatch is not defined as a general matter. Rather, it is specifically defined for the purposes of
Recommendations 1, 3, 4, 6, and 7 in each of those recommendations
(Paragraph 3). This diversity of definitions reflects the overall complexity of the report.
Recommendations for domestic laws
Categories of hybrid mismatch arrangements
The report's fundamental principles have not changed from previous drafts. The two main types of mismatches identified are payments that (i) are deductible under the rules of the payer and not included in the income of the recipient (deduction/no inclusion or ‘D/NI’ outcomes) or (ii) give rise to duplicate deductions from the same expenditure (double deduction or ‘DD’ outcomes).
D/NI outcome – A deduction/no inclusion outcome arises where a deduction is given for the company making a payment while the receipt is not fully taxable as ordinary income in the hands of the payer. Timing differences in the recognition of payments or differences in the way jurisdictions measure the value of money do not, of themselves, generate a D/NI outcome. The final report clarifies, however, that a timing mismatch may be considered permanent (and thus subject to the rule) if the taxpayer cannot establish to the satisfaction of a tax authority that it will recognize a payment within a defined period.
Ordinary income – ‘Ordinary income’ is any income effectively subjected to the full marginal tax rate in the recipient’s territory of residence.
Income is viewed as taxable even if there are other deductions available to offset it. The final report has added an exception allowing tax incurred under a parent’s controlled foreign corporation (CFC) regime to suffice, although the report also treats foreign tax credits as an offset that may render income non-taxable for this purpose.
DD outcome – A payment gives rise to a DD outcome if the payment is deductible under the laws of more than one jurisdiction.
The third type of mismatch is where non-hybrid payments from a third country can offset hybrid mismatch arrangement deductions and thus are not effectively taxed in the recipient's hands (an indirect deduction/no inclusion or ‘indirect D/NI’ outcome).
Within these three categories of hybrid mismatch arrangements are the different types of hybrid transactions and entities the report specifically addresses:
 D/NI outcomes
(Recommendations 1-5)
– Hybrid financial instruments
(including transfers): covering deductible payments made under a financial instrument that is not taxed as ordinary income in the payee’s jurisdiction.
– Disregarded hybrid entity payments: covering deductible payments that are not taxed as ordinary income in the payee’s jurisdiction because the payee jurisdiction does not recognise the payment.
– Payments made to reverse hybrids: covering payments made by an intermediary payee where the differences in characterisation of the intermediary entity by its own jurisdiction and its investor’s jurisdiction results in the exclusion of payments from ordinary income in both of those jurisdictions.
 DD outcomes (Recommendations
6-7)
– Deductible hybrid entity payments: covering deductible payments made by a hybrid entity that could trigger a duplicate deduction in the parent jurisdiction.
– Deductible payments made by a dual resident company: covering payments made by a company treated as a resident by more than one jurisdiction.
 Indirect D/NI outcomes
(Recommendation 8)
– Imported mismatch arrangements: covering arrangements where the intermediary jurisdiction is party to a separate hybrid mismatch arrangement, and the payment from another jurisdiction to the intermediary jurisdiction
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Tax Policy Bulletin under a non-hybrid arrangement offsets a deduction arising under the hybrid mismatch arrangement to which the intermediary is a party.
Payments – Defined broadly as any amounts capable of being paid, including accrued amounts that will ultimately be payable. Payments that are only deemed to arise for tax purposes are specifically excluded; there is an example of notional interest deductions for equity. The definition is not limited by reference to financial payments and so would include, for example, rent, royalties and payments for services.
Observation: Presumably, the exception for payments deemed to arise for tax purposes would cover all such amounts and not just notional interest deductions for equity, which is the example given.
Arrangement – Broadly defined as an agreement, contract, scheme, plan, or understanding, whether enforceable or not, including all steps and transactions by which it is carried into effect. An arrangement may be a single arrangement, part of a wider arrangement or comprised of a number of arrangements.
The recommendations only apply to payments that result in a hybrid mismatch. The recommendations have a common format, which includes a Primary Rule, a Defensive
Rule (for another jurisdiction to apply where the Primary Rule is not in place), specifications for the types of entities and payments subject to the rule, and the scope of situations to which the rule applies.
Recommendation 1: Hybrid financial instrument rule
Recommendation 1 is an extensive rule addressing payments under a financial instrument that result in a hybrid mismatch. Its complexity is reflected in Annex B of the report, which sets forth 37 examples related to this rule.
The Primary Rule for
Recommendation 1 is that the payer jurisdiction denies the deduction to the extent it gives rise to a D/NI outcome. (See Example 1 below.) To the extent the payer jurisdiction does not deny the deduction, under the
Defensive Rule the payee jurisdiction should ensure that the payee includes the payment in ordinary income.
Example 1
Country A
No income recognised
Hybrid instrument payment
For purposes of this rule, a ‘hybrid mismatch’ only comes into play where the mismatch can be attributed to the instrument's terms. (See Example 2
Country B
X below.) A payment cannot be attributed to the instrument's terms where the mismatch is solely attributable to the taxpayer's status or the circumstances in which the instrument is held.
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Financial instrument payment
Example 2
Country A
Tax-Exempt
Fund
Income exempted
Country B
X
Observation: The report clarifies that the hybrid financial instrument rule only applies where the hybrid mismatch is attributable to the terms of the instrument itself. However, an arrangement may give rise to a hybrid mismatch under other rules in this report due to the taxpayer's status or the circumstances in which the instrument is held.
Recommendation 1 applies to both hybrid financial instruments and hybrid transfers.
A ‘financial instrument’ is defined as any arrangement that both the payer and payee jurisdictions tax under the rules for taxing debt, equity or derivatives. The report has expanded the scope of this definition, stating that a jurisdiction should treat any arrangement where one person provides money to another in consideration for a financing or equity return as a financial instrument (to the extent of that return).
Furthermore, following the counteraction principle, any payment that the counterparty jurisdiction does not treat as a financial instrument would be treated as giving rise to a mismatch -- but only to the extent the payment constitutes a financing or equity return. Finally, a ‘substitute payment’ would be a payment that includes or represents a financing or equity return on a financial instrument that is subject to a transfer arrangement, where the payment or return (i) would not have been included in the payer’s ordinary income; (ii) would have been included in the payee’s ordinary income; or (iii) would have given rise to a hybrid mismatch, if it had been made directly under the financial instrument.
‘Hybrid transfers’ include any arrangement to transfer a financial instrument where the taxpayer is the owner (legal or beneficial) of the transferred asset and the taxpayer’s jurisdiction treats the counterparty’s rights in that asset as the taxpayer’s obligations, but the counterparty’s jurisdiction treats the counterparty as the owner and the taxpayer’s rights as the counterparty’s obligations.
The hybrid financial instrument rule would apply only to instruments and transfers entered into with related parties or in structured arrangements.
Related persons – As defined in
Recommendation 11, two persons are related if they are in the same ‘control group’ or have at least 25% common ownership (directly or indirectly, by vote or value). Being in the same control group means (i) they are consolidated for financial accounting purposes, (ii) one person has effective control over the other (or a third person over both), (iii) one person has at least a 50% investment in the other
(directly or indirectly, by vote or value), or (iv) they can be regarded as
‘associated enterprises’ under the
OECD Model Treaty’s Article 9.
Observation: The ‘related person’ threshold has been retained from the prior deliverable, where it was increased from 10% in the first discussion draft. Some observers feel that 25% common ownership is still too low, since it would not normally be high enough to allow the owner to determine business or tax arrangements, absent other factors.
Structured arrangement – As defined in Recommendation 10, a ‘structured arrangement’ is one where (i) the hybrid mismatch is priced into the terms of the arrangement or (ii) the facts and circumstances (including the terms) of the arrangement indicate that it has been designed to produce a hybrid mismatch.
The report specifies that structured arrangements include arrangements that:
 are designed to create a hybrid mismatch
 incorporate a term, step or transaction to create a hybrid mismatch
 are marketed as products with a tax advantage deriving from a hybrid mismatch
 are primarily marketed to taxpayers in a jurisdiction where the hybrid mismatch arises pwc

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 provide a contingency modifying the arrangement should a hybrid mismatch no longer be available
 would produce a negative return absent a hybrid mismatch.
Taxpayers would not be party to a structured arrangement if they were not aware of the hybrid mismatch and did not recognise any tax benefit from it.
The final report retains an exception to the hybrid financial instrument rule where the payer jurisdiction’s tax policy for the deduction is to preserve tax neutrality for the payer and payee.
The exception addresses a payment by an investment vehicle (if not made under a structured arrangement) that is subject to the establishment jurisdiction’s special regulation and tax treatment, as follows:
 The deduction for the payment is preserved to ensure that the taxpayer is subject to minimal (or no) taxation on its investment income, while holders of financial instruments issued by the taxpayer are subject to current tax on that payment as ordinary income.
 The investment vehicle’s financial instruments will result in substantially all of the taxpayer’s investment income being paid and distributed to the holders of those financial instruments within a reasonable period of time after the taxpayer received that income.
 The full amount of the payment is
(i) included in the ordinary income of any person that is a payee in the establishment jurisdiction and (ii) not excluded by a tax treaty from the ordinary income of any person that is a payee under the laws of the payee jurisdiction.
This exception applies to special entities such as real estate investment trusts (REITs). (See Example 3 below.)
Example 3
No dividend exemption Country A
Other
Investors
Dividend
25% 75%
The final report reflects further work where the OECD addressed various issues relating to financial instruments, entities, and transactions. This work includes considerations of repos and stock lending, on which the report offers five examples.
Observation: There is an outstanding question on how repo or stock lending transactions should be treated for banks, funds and financial traders. While the OECD has provided additional guidance, there are still a number of points to
Country B
REIT
Deduction consider, particularly for intra-group arrangements that are not excluded.
Given the importance of repo and stock lending as a source of shortterm financing for the financial sector, this will be a key area of concern for most financial institutions with crossborder funding arrangements on which the OECD should provide clarity. For example, the compliance burden of demonstrating that all stock loans and repos either (i) are not structured arrangements (to which the rules apply, even in third-party situations) or (ii) do not give rise to any hybrid mismatches with counterparties could be extremely difficult, not least given the size of the repo and stock lending markets.
Certain issues regarding financial instruments still remain open. In particular, the report’s Executive
Summary notes that jurisdictions are free to decide whether or not hybrids’ rules should apply to mismatches from intra-group hybrid regulatory capital, without regard to whether other jurisdictions do so.
Observation: For financial institutions, instruments issued for
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In practice, externally-issued instruments will generally not be caught by hybrids' rules, since they are unlikely to be ‘structured arrangements’. However, where there has been an intra-group pushdown of externally-issued instruments, financial institutions should evaluate whether there could be unintended adverse consequences.
Note that a variety of common fact patterns that give rise to a D/NI result would not be subject to
Recommendation 1, to the extent they are not hybrid mismatches under terms of a financial instrument.
Observation: The rules in
Recommendation 1 could affect a variety of intragroup hybrid instruments that some multinationals might use from a US company to a non-US company or between non-US companies. To the extent that an instrument operates only between two
EU companies, it would generally be subject to the amended Parent-
Subsidiary Directive, which must be enacted into domestic law by 31
December 2015. The EU has taken an approach that resembles
Recommendation 2 (see below) more than Recommendation 1.
To prevent any duplication of tax credits under a hybrid transfer, the report also recommends that any jurisdiction granting relief for tax withheld at source on a payment made under a hybrid transfer should restrict the benefit of such relief in proportion to the taxpayer’s net taxable income under the arrangement.
Observation: The participation exemption rule is similar to the EU’s approach in amending the Parent-
Subsidiary Directive.
Recommendation 2: Specific recommendations for the tax treatment of financial instruments
Recommendation 2 provides an additional domestic law approach to address D/NI arrangements, with no limitation as to scope. Specifically, where domestic law generally provides for a participation exemption, the
OECD suggests that jurisdictions should not grant such an exemption for all dividends (not only relatedparty dividends) that have given rise to a deduction in another jurisdiction.
Recommendation 3: Disregarded hybrid payments rule
For disregarded hybrid payments,
Recommendation 3 suggests that, under the Primary Rule, the payer jurisdiction should deny the deduction. (See Example 4 below.) If the payer jurisdiction does not deny the deduction, then, under the
Defensive Rule, the payee should include the payment in ordinary income.
Example 4
Country A
No income recognised
Payment
The rule does not apply to the extent the deduction offsets dual inclusion income (income subject to tax as ordinary income in both the payer and payee jurisdictions). Excess deductions may be carried forward and offset future dual inclusion income.
Country B
X
The rule will only operate where a hybrid payer makes a disregarded payment. A hybrid payer is a person where the tax treatment of the payer
(by the payee jurisdiction) causes the payment to be disregarded. A disregarded payment is a payment that is deductible in the payer jurisdiction but not included in income by the payee jurisdiction. The rule applies only to payments (i) between related persons in the same control group or (ii) made under a structured arrangement to which the taxpayer is a party. pwc

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Observation: This recommendation would clearly impact certain first-tier disregarded intragroup loans that some US multinationals might use.
Recommendation 4: Reverse hybrid rule
Under Recommendation 4’s Primary
Rule for payments to reverse hybrids,
Example 5 the payer jurisdiction denies the deduction to the extent it gives rise to a D/NI outcome. There is no
Defensive Rule. (See Example 5 below.)
Parent
No income recognised
Country
A
Payment
Although the OECD uses the US term
‘reverse hybrid,’ the term does not have the same meaning as under US federal income tax law. Rather, a reverse hybrid is defined as any entity that is treated as a separate entity by any investor and as transparent under the laws of the establishment jurisdiction.
The reverse hybrid rule would apply only where a payment results in a hybrid mismatch that would not have arisen had the accrued income been paid directly to the investor. Its scope is limited to situations where the investor, the reverse hybrid and the payer are members of the same control group, or if the payment is part of a structured arrangement to which the payer is a party.
Observation: Recommendation 4 could have unexpected effects on certain structures, where a transparent entity’s indirect investor may be located in a jurisdiction that sees the entity as separate, even though intermediate jurisdictions in the chain also see the entity as transparent. The rule could also affect certain structures involving top-tier
Country B X reverse hybrids that some multinationals might use.
Recommendation 5: Specific recommendations for the tax treatment of reverse hybrids
Recommendation 5 provides three general suggestions for domestic law changes addressing issues raised by reverse hybrid arrangements:
 Instituting or improving offshore investment (CFC) regimes to prevent D/NI outcomes from arising with respect to payments to a reverse hybrid (or in relation to imported mismatch arrangements). Specific suggestions for possible improvements include changes to residency rules, CFC rules and rules that tax a resident investor on changes in an investment's market value.
 Limiting tax transparency for non-resident investors . The report recommends treating reverse hybrids as resident taxpayers in the establishment jurisdiction if the reverse hybrid’s income is not otherwise taxable in that jurisdiction and the accrued income of a non-resident investor in the same control group is not taxable in the investor jurisdiction.
 Information reporting for intermediaries. The OECD recommends that jurisdictions introduce appropriate tax filing and information reporting requirements on persons established within their jurisdiction in order to assist both taxpayers and tax administrations to properly determine the payments that have been attributed to that non-resident investor.
Observation: The report addresses a controversial issue in previous drafts by treating a payment that is included as income in the parent jurisdiction under a CFC regime as if it had been included in ordinary income by the payee (beyond any offsets to the CFC inclusion). The report signals, though, that the OECD will continue to work on the interaction between hybrids rules and CFC regimes. pwc

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Recommendation 6: Deductible hybrid payments rule
Recommendation 6 addresses payments by a ‘hybrid payer’ that are deductible both in the payer jurisdiction and in the parent jurisdiction. The Primary Rule, with no scope limitation, is for the parent jurisdiction to deny the duplicate deduction to the extent it gives rise to a DD outcome. (See Example 6 below.) The Defensive Rule is for the payer jurisdiction to deny the
Example 6 duplicate deduction, to the extent it gives rise to a DD outcome. That rule would apply only if the parties to the mismatch are in the same control group or a structured arrangement.
Country A
X
Unrelated
A hybrid payer for this purpose is a person making a payment that is deductible under the laws of the payer jurisdiction where (i) the payer is not a resident of the payer jurisdiction and the payment triggers a duplicate
Country B
Deduction
Payment deduction for that payer (or a related person) under the laws of the jurisdiction where the payer is resident (the parent jurisdiction); or
(ii) the payer is resident in the payer jurisdiction and the payment triggers
Example 7 a duplicate deduction for an investor in that payer. The rule does not apply to the extent the deduction offsets dual inclusion income, as defined above. (See Example 7 below.)
Partial income inclusion
Country A
X
Unrelated
Excess deductions, beyond dual inclusion income amounts, may be carried forward and offset future dual inclusion income. To prevent stranded losses, the excess deduction may be allowed to the extent that the taxpayer can show that the deduction in the
Partial income inclusion
Country B
Payment
Deduction other jurisdiction cannot offset any person’s income.
Recommendation 7: Dual resident payer rule
Recommendation 7 covers payers that are dual consolidated companies, that is, taxpayers considered a tax resident by two or more jurisdictions. This rule addresses such companies’ payments that are deductible under the laws of more than one of those jurisdictions. The Primary Rule is for all of the payer’s resident jurisdictions
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Tax Policy Bulletin to deny the duplicate deduction, to the extent it gives rise to a DD outcome.
There is no scope limitation for this recommendation and no need for a
Defensive Rule.
As with Recommendation 6, this rule does not apply to the extent the deduction offsets dual inclusion income. Excess deductions (beyond dual inclusion amounts) may be carried forward and offset future dual inclusion income. The excess deduction may be allowed to the extent that the taxpayer can show that the deduction in the other jurisdiction cannot offset any person’s income.
Observation: The rules in
Recommendations 6 and 7 are very similar in concept to the US dual consolidated loss (DCL) rules. The
DCL regime is very complex (US regulations in this area are 61 pages long), and one could expect this rule to provide similar challenges for both taxpayers and tax authorities.
Recommendation 8: Imported mismatch rule
Recommendation 8 addresses
‘imported mismatches’. These are defined as arrangements that give rise to a hybrid mismatch under the laws of another jurisdiction, and the effect of that mismatch is imported into the payer jurisdiction by offsetting the deduction under that hybrid mismatch arrangement against the
Example 8
Parent
No income recognised income from the payment. An imported mismatch payment is a deductible hybrid mismatch payment made to a payee that is not subject to hybrid mismatch rules.
The Primary Rule is for the payer’s jurisdiction to deny the deduction, to the extent the payment gives rise to an indirect D/NI outcome. Specifically, the OECD recommends that the payer jurisdiction apply a rule denying a deduction for any imported mismatch payment pro rata, that is, to the extent the payee treats that payment as an offset to a hybrid deduction in the payee jurisdiction. (See Example 8 below.)
Reverse
Hybrid
100 interest
Country B
Deduction
9
Country B
100 interest
For this purpose, a ‘hybrid deduction’ means a deduction resulting in a
Country C X hybrid mismatch that derives from: (i) a payment under a financial instrument; (ii) a disregarded payment made by a hybrid payer; (iii) pwc

Tax Policy Bulletin a payment made to a reverse hybrid; or (iv) a payment made by a hybrid payer or dual resident that triggers a duplicate deduction, and includes a deduction resulting from a payment made to any other person to the extent that person treats the payment as an offset to another hybrid deduction.
The rule would apply only where (i) the taxpayer is in the same control group as the parties to the imported mismatch arrangement, or (ii) the payment is made under a structured arrangement, and the taxpayer is party to that structured arrangement.
There is no Defensive Rule.
Observation: Recommendation 8 is likely to be the source of greatest complexity for both taxpayers and tax authorities. It asks for extensive knowledge of multiple jurisdictions’ tax laws, as well as the facts and
Example 9
Parent
100 ordinary income
(under CFC rules) circumstances of every person that may be viewed under the relevant tax laws as part of an imported mismatch situation. This rule could lead to an unfavorable asymmetry for taxpayers.
For example, a taxpayer may be denied a deduction even if an imported mismatch results in a CFC inclusion in the investor jurisdiction.
(See Example 9 below.)
Reverse
Hybrid
100 interest
Country A
100 interest
Country B
X
In general, taxpayers will need to prove income inclusions in intermediary or investor jurisdictions
(or a denial of deductions in an intermediary jurisdiction) to avoid denial of a deduction in the nonhybrid payer country. It is easy to see that there will be enormous complexity in applying the pro rata deduction denial rule in many situations. For example, imagine that
Country A company above is a treasury company making multiple loans, from multiple sources, in multiple currencies to multiple borrowers. There will also be difficulties in obtaining information from all participating non-controlled parties in a structured transaction.
Some jurisdictions possibly may find this rule too difficult to administer and may decline to adopt these imported mismatch rules; uneven adoption is likely to result in double taxation. The complexity that
Recommendation 8 could generate, especially where there is non-uniform adoption, is demonstrated in Example
10 below. This example assumes that countries may adopt the hybrid mismatch rule and all its complexities fully, partially, or not at all. Such nonuniform adoption can lead to double taxation when countries that fully or partially adopt the rule deny more than their appropriate share of a deduction:
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Example 10
50 equity
25 loans
75 hybrid loans
Tax- exempt investors
CIV
Other investors
(Country A)
50 equity
25 loans
75 hybrid loans
300 cash
Fiscal unity
100 loan
Country A
100 loan
11
X
Country B
100 loan
Country C Country D
Full denial
(100)
X
This shows that the countries involved may adopt imported mismatch measures with no pro rata rule (as it is too complex) or not enough information to apportion correctly or by applying it wrongly, thus denying too much and resulting in double taxation. The guidance states that the process might be better if multinationals do the necessary calculations and present them to the relevant tax administrations.
Treaty issues
Scope of provisions
The OECD has made recommendations to ensure that hybrid instruments and entities are not used to obtain treaty benefits inappropriately. The recommendations cover the following situations, set out in more detail below:
Deduction
 dual resident entities
 transparent entities, and
 interaction between the domestic hybrid (and other) recommendations and tax treaty provisions.
Dual resident entities
Domestic legislation
Recommendation 7 above deals with counteractions related to payments involving dual residents. However, there is a proposal to widen the existing dual resident tie-breaker rule
(Article 4(3)) under the Model Treaty.
The revised rule would state that residence in such cases should be determined not only by place of effective management, but also by place of incorporation or constitution and ‘other relevant factors’.
Observation: The inclusion of such a broader clause creates subjectivity and greater uncertainty for business. For example, a lack of agreement between two jurisdictions results in no relief except as agreed by the competent authorities. The intent is to have, in effect, a case-by-case analysis but instead may lead to protracted disputes.
To supplement this, the OECD suggests that countries may consider a rule that an entity that is considered to be a resident of another state under a tax treaty, under the expanded rule, will be deemed not to be a resident under domestic law (this applies if other anti-abuse rules insufficiently address mismatches between the treaty and domestic law concepts of residence.) pwc

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Example 1: State A has a 25% tax rate, State B has a 15% tax rate.
Entities 1 and 2 are resident in State
A under the domestic law of that state. Entity 1 is resident in State B under domestic law in that state and under the A-B treaty (as adjusted in relation to the Article 4(3) BEPS amendment). If Entity 1 makes a profit in State B, it may under the A-B treaty be taxable only in State B at
15%. If Entity 1 incurs a loss in State
B, the concern is that it could, under the tax consolidation rules in State A, offset that loss against profits of
Entity 2, effectively obtaining relief at
25%. Including such a domestic rule in State A that would make Entity 1 a non-resident there deals with this situation.
Example 2: State A has a 25% tax rate, State B has a 15% tax rate.
Entity 1 is resident in State A under the domestic law of that state. Entity
2 is resident in State B under the domestic law of that state. Entity 3 is resident in both State A and State B under the domestic laws of those states. If Entity 3 incurs a loss, the concern is that the loss could effectively be taken into account under the tax consolidation rules of both State A and State B, reducing the taxable profits of Entity 1 and Entity
2. (This is similar to the situation in
Example 7.1 in relation to payments involving a dual resident.)
2A - If an A-B treaty existed, and the domestic law of each state included such a domestic rule, Entity 3 would likely be a resident for the purposes of domestic tax consolidation in only one state, i.e. the state of which it would be a resident under the treaty.
2B - If only one of the states includes such a domestic rule, a difficulty potentially arises – say, State A has the rule while State B does not, Entity
3 might be considered under the A-B treaty to be resident in State A rather than State B and the rule does not apply since Entity 3 is not considered to be a resident of State B under a tax treaty, so continues to be resident for the purposes of domestic tax consolidation in both states.
Observation: The inclusion of a non-residency domestic provision of this type creates greater certainty for business and tax administrations. A number of jurisdictions have already implemented (such as the United
Kingdom) or considered such a provision recently.
Transparent entities
The OECD recommends widening the existing Model Treaty rule with regards to persons covered (Article 1)) to ensure that a transparent entity's income attracts tax treaty benefits in appropriate cases, but also that these benefits are not granted where neither
Contracting State treats, under its domestic law, that entity's income as one of its residents' income.
The Model Treaty Commentary will be enhanced accordingly. It will specifically refer to the principles reflected in the 1999 report of the
Committee on Fiscal Affairs entitled
‘The Application of the OECD Model
Tax Convention to Partnerships', which was imported into the
Commentary. The guidance and examples in that report on how to interpret and apply the provision in various situations for partnerships would therefore be extrapolated to other transparent entities with appropriate modifications. That includes a degree of continuity, but in other respects makes interpretation more difficult.
Observation: Taxpayers may incur tax up-front and may seek a refund, with the inherent delays that may entail. States will in some respects be encouraged by the guidance to take that approach since they will not be
“ expected to grant the benefits of a bilateral tax convention in cases where they cannot verify whether a person is truly entitled to these benefits .
”
This applies for the purposes of treaty interpretation (e.g., withholding tax or
WHT) and does not, therefore, require a state to change the way in which it attributes income or characterises entities for the purposes of its domestic law.
Example 1: Entity 1, established in
State B, is regarded under State A domestic law as a company and a partnership in State B ‘owned’ equally by members Entity 2 and
Entity 3. Entity 2 is a resident of
State B and Entity 3 is a resident of
State C. A payment of 100 by a resident of State A to Entity 1 prima facie attracts WHT at State A’s domestic rate of 20%.
Under the A-B Treaty, half of the potential receipt of 100 by Entity 1 is considered to be income of a resident of State B for WHT purposes. So 50 will attract WHT at 20% and 50 will attract WHT at the reduced 10% rate under the A-B Treaty. But Entity 1 remains the relevant taxpayer for the purposes of State A’s domestic law.
However, where an entity is treated as partly fiscally transparent under the domestic law of one of the Contracting
States, part of the entity's income might be taxed at the level of the persons who have an interest in that entity, while part would remain taxable at the entity level. The revised
Commentary provides an example of some rules for trusts where the part of the income derived through a trust that is distributed to beneficiaries is taxed in the hands of these beneficiaries, while the part of that income that is accumulated is taxed in the hands of the trust or trustees.
The Commentary will be amended to clarify the meanings of 'income derived by or through an entity or
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Tax Policy Bulletin arrangement', 'income' and 'fiscally transparent'.
Interaction between domestic rules and treaties
The report acknowledges the need to coordinate the Model Treaty with domestic law BEPS recommendations.
The report notes that under Action 6
(Preventing Treaty Abuse) a number of specific recommendations may play an important role in ensuring that hybrid instruments and entities (as well as dual resident entities) are not used to obtain treaty benefits unduly.
It highlights the following provisions that may be of particular relevance:
 the elimination of double taxation
 non-discrimination (as long as the domestic rules that will be drafted to implement these are effectively worded).
Observation: The interaction between particular provisions in both domestic and international tax rules has proven difficult to predict.
Thankfully, the OECD has considered and opined on a number of specific issues, but practical issues likely will need to be addressed when they arise.
Implementation and timing
Start and transition
The final recommendations do not include any specific start date or transition rules. These should be determined as agreed in
Recommendation 9.2:
 limitation-on-benefits (LOB) rules and/ or the principal purpose test
(PPT)
 rules aimed at dividend transfer transactions (i.e., to subject the lower rate of tax provided certain treaty provisions to a minimum shareholding period)
 rules concerning a Contracting
State’s right to tax its own residents
 anti-abuse rules for permanent establishments situated in third states.
It also considers the extent to which
Recommendations 1-12 above have potential consequences for the countries adopting them. It notes that problems could arise for treaties that allow the exemption method to apply with respect to dividends received from foreign companies and describes possible treaty changes that would address them. It largely concludes that otherwise there are no interaction issues concerning:
 denial of a deduction
 inclusion of a payment in ordinary income
 the recommendations state transition rules will be without any presumption of grandfathering existing arrangements
 when an effective date is agreed, the report states that it should be far enough in advance “to give taxpayers sufficient time to determine the likely impact of the rules and to restructure existing arrangements to avoid any adverse tax consequences associated with hybridity”
 all payments under hybrid mismatch arrangements that are made after the effective date of the legislation or regulation should then be affected according to the report – to avoid unnecessary complication and the risk of double taxation, the report suggests the rules should generally take effect from the beginning of a taxpayer’s accounting period.
Observation: These issues are important, given the many existing arrangements involving hybrid transfers and entities. Any changes to an existing arrangement may create a substantial cost to businesses and require time to adapt to the proposed recommendations.
Drafting
The report recognises that the wording of relevant legislation or regulations will have to be specific to each jurisdiction, bearing in mind the existing legislative structure and nature of the rule of law – one of the
‘design principles’ in
Recommendation 9.1. The measures should also “minimise the disruption to existing domestic law”.
When implementing these recommendations, jurisdictions have been encouraged to ensure the counter measures also minimise the administrative burden for taxpayers and tax authorities. In particular, the report specifies that the rules should be comprehensive, clear and transparent.
The counter measures a jurisdiction introduces should apply automatically and aim to neutralise the mismatch between jurisdictions rather than reverse the tax benefit that arises under the laws of that particular jurisdiction.
Observation: The lack of a motive or purpose test in the recommendations may create unintended consequences. There is also a lack of recognition that a jurisdiction's anti-hybrid rules are just one part of the overall fiscal policy of a jurisdiction that has been set to achieve the jurisdiction's specific economic aim. In that sense, jurisdictions might consider them from a policy perspective in the same way as other tax and non-tax levers such as, for example, the overall corporate tax rate, tax incentives and legal and fiscal governance.
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Co-ordination within the anti-hybrid rules
The report recommends that a jurisdiction focus on ensuring coordination of its anti-hybrid rules (as well as the interaction with other rules applicable in the jurisdiction, as noted below). Note that jurisdictions will be co-operating on how to ensure these recommendations are implemented and applied consistently and effectively across states. The extent of the required coordination activity indicates one area of complexity in the implementation process:
 applying the hybrid mismatch recommendations in the following order of precedence: hybrid financial instrument rule; reverse hybrid rule/ disregarded hybrid payments rule; imported mismatch rule; and deductible hybrid payments rule/dual resident entity rule
 considering specific measures for certain situations (e.g., financial instruments) where there may or may not be a mismatch in outcomes between jurisdictions
 any relationship with existing antihybrid or anti-arbitrage rules
(unless those are to be repealed)
 applying the primary and secondary rules appropriately, particularly where the rules apply in situations where the counterparty jurisdiction introduces hybrid mismatch rules from a date that is part way through the taxpayer’s accounting period (the ‘switch-over period’).
The switch-over period recommendation is, in relation to a cross-border payment, that:
“(a) The secondary or defensive rule will apply to any amount that is treated as paid, under the laws of the payee jurisdiction (Country A), in a period prior to the commencement of the switch-over period.
(b) The primary rule will apply to any amount that is treated as paid, under the laws of the payer jurisdiction
(Country B), during the switch-over period (after taking into account any amounts caught by the secondary rule in accordance with paragraph (a) above).
(c) Any other payments that give rise to a hybrid mismatch and that are not captured by paragraph (b) above will be caught by the application of the secondary rule.”
Example: Entity 1 in Country A has a calendar year accounting period during which it receives annually from Entity 2 in Country B a payment of 200 under a hybrid financial instrument. Country A has adopted the hybrid recommendations for some time (and has therefore taxed the income under the secondary rule) while Country B adopts the hybrid recommendations with effect from its tax year beginning 1 April in that year. Country A applies the accrual basis to a payment of this kind while Country B has a more complex revenue/ expense recognition process.
In Entity 2’s tax computation in
Country B, as a result of the adoption of the hybrid recommendations a deduction is denied for say 140, being the interest that arises during the switch-over period (say 190) less the portion of the payment that has been taken into account in Country A prior to 1 April (50).
In Entity 1’s tax computation in
Country A, the income will be taxed to the extent the mismatch has not been eliminated by the primary rule in
Country B, so 60. (The report states that if, in practice, it would be unduly burdensome to require Entity 1 to determine the actual amount of the payment that has been subject to adjustment in Entity 2 in Country B, the amount to be taxed in Entity 1 can be calculated based on the amount accrued under Country A law for the switch-over period where the primary rule will not apply i.e., 1
January to 30 March, so it would seem 50).
Observation: There is considerable complexity in how countries should apply these rules to multinationals, particularly where the tax years/ accounting periods are not coterminous or countries’ rules are not identical. The examples in the report will need to be supplemented further with more explicit examples if they are to deal with various situations that will arise in practice.
Interactions with other rules
The report refers to the need to:
 co-ordinate the hybrid mismatch rules and other transaction specific rules and other anti-abuse rules - to apply consistently with other rules of the domestic tax system so that the interaction does not result in double taxation of the same economic income, and
 co-ordinate with the rules in a third jurisdiction (such as CFC rules) which subject payments to taxation in the residence state of the investor.
In particular, the report acknowledges that interaction exists between this and related Actions in the OECD
BEPS process, specifically Actions 3
(on strengthening CFC rules) and 4
(on limiting base erosion via interest deductions and financial payments).
The OECD and the European
Commission (EC) have consistently stated that the EC has been actively involved in the BEPS deliverables and ensuring compliance with the Treaty on the Functioning of the EU and /or
EEA agreement in intra-EU/EEA
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Tax Policy Bulletin cases. The application of EU law to the proposed recommendations is however complex. For example, recommendations for the D/NI and
Indirect D/NI outcomes might potentially be seen as discriminatory measures under such EU law to the extent that they are regarded as rules that only operate with respect to cross border situations and with respect to non-taxation in the payee state. If so they may still be justifiable on
‘Cadbury grounds’ where they are limited to ‘wholly artificial arrangements’. It is not clear whether the EC would view hybrid arrangements generally as being wholly artificial within this context or whether they may consider the rules justifiable on other grounds (e.g., coherence and/or allocation of taxing powers). Furthermore, as regards the
DD rules, it is not clear that the defensive rule denying a deduction in the payer jurisdiction is consistent with the decision in Phillips
Electronics. This suggests that the payer jurisdiction should not seek to deny a deduction based on treatment in an investor jurisdiction.
Observation: Having identified the interaction with measures on interest deductibility and CFCs, there is an added complication in having hybrids rules that apply in these situations.
Further, while the acknowledgement of potential interaction between measures under different action items is welcome and essential, some crossover might also be considered in relation to other Actions – 5 (on harmful tax practises), 6 (on treaty benefits) and, potentially 12
(disclosure of aggressive tax planning).
Continuing review and exchange
The OECD will continue to review the effective and consistent implementation of the recommendations in accordance with
Recommendation 9.2 and the commitments made in that section.
The OECD recognizes the need for a regular exchange of information between jurisdictions on their treatment of hybrid arrangements
(e.g., through the Joint International
Tax Shelter Information Centre, or
JITSIC) and of spontaneous exchange related to specific taxpayer circumstances (via legal instruments such as tax treaties, Tax Information
Exchange Agreements (TIEAs) and the Convention on Mutual
Administrative Assistance in Tax
Matters (OECD 2010)).
The report notes that tax administrations (and the OECD) should make relevant information available to taxpayers. The guidance/ commentary included in the report, and the commitments made to update it ‘periodically’, is intended to help taxpayers as well as tax administrations. The report suggests that there is also an onus on individual tax administrations to ensure taxpayers are aware of the treatment of hybrid arrangements under their domestic laws, but some have historically been much better at doing this than others.
Observation: There is a concern over the complexity and workability of rules that require taxing authorities to know, in detail, the taxation treatment in other jurisdictions. Taxpayers in some jurisdictions may not be confident that their tax administration would publish detailed guidance on the operation of their domestic antihybrid rules.
The final report generally confirms the concepts and recommendations in the
September 2014 hybrids deliverable, adding many examples and some exceptions. In particular, a new exception prevents the denial of deductions to the extent that a hybrid mismatch payment is included as ordinary income under the CFC regime of the investor's home jurisdiction.
The report’s treaty recommendations have limited scope, but the domestic law recommendations create significant complexity, particularly with respect to ‘imported mismatches’. It is unclear how many jurisdictions will adopt those recommendations fully. Some jurisdictions may enact all of the
OECD’s concepts, but others may only use the more easily administered rules. Certain jurisdictions have already put in place their own antihybrid regimes. It is not yet clear if those jurisdictions will expand their legislation to include additional recommendations, such as the imported mismatch rules, given their complexity. The jurisdictions with existing anti-hybrid rules may feel those rules (and related provisions) adequately address base erosion from cross-border payments.
Non-uniform adoption of the OECD recommendations could result in double taxation and affect investment decisions. Companies and other investors may be unwilling to make substantial funding commitments in jurisdictions that apply the hybrid report’s concepts in a manner likely to result in double taxation. The Dutch government, for one, has stated that it will not unilaterally tighten rules governing hybrids but will continue to ensure that the Netherlands remains attractive for foreign investment.
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Tax Policy Bulletin
For a deeper discussion of how this issue might affect your business, please contact:
Neutralise the effects of hybrid mismatch arrangements
Justin Woodhouse, St Helier
+44 (0) 1534 838233 justin.woodhouse@je.pwc.com
Suchi Lee, New York
+1 (646) 471-5315 suchi.lee@us.pwc.com
Calum Dewar, New York
+1 (646) 471-5254 calum.m.dewar@us.pwc.com
Michael Urse, Cleveland
+1 (216) 875-3358 michael.urse@us.pwc.com
Jonathan Hare, London
+44 (0)20 7804 6772 jonathan.hare@uk.pwc.com
Neil Edwards, London
+44 (0)20 7213 2201 neil.edwards@uk.pwc.com
Peter Collins, Melbourne
+61 (3) 8603 6247 peter.collins@au.pwc.com
Greg Lubkin, Washington
+1 202-414-1542 greg.lubkin@us.pwc.com
Tax policy
Pam Olson, Washington
+1 (202) 414 1401 pam.olson@us.pwc.com
Edwin Visser, Amsterdam
+31 (0) 88 7923 611 edwin.visser@nl.pwc.com
Richard Collier, London
+44 (0) 20 7212 3395 richard.collier@uk.pwc.com
Phil Greenfield, London
+44 (0) 20 7212 6047 philip.greenfield@uk.pwc.com
Stef van Weeghel, Amsterdam
+31 (0) 88 7926 763 stef.van.weeghel@nl.pwc.com
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