The Anti-Tax Avoidance Directive II’s hybrid mismatch rules and tax neutral jurisdictions Copy of Article Id: 8574

James O'Neal

Maples and Calder, Luxembourg

james.o'neal@maples.com

The European Union's Anti-Tax Avoidance Directive II (ATAD II)^[1]has expanded EU Member States' abilities to deny tax benefits resulting from perceived abuses of aggressive tax planning (ATP) involving hybrid entities and hybrid instruments.^[2] ATAD II's hybrid mismatch rules can cause the denial of an otherwise tax-deductible expense in an EU Member State that does not result in a corresponding inclusion of income in another jurisdiction (D/NI outcome) or results in a double deduction involving one or more jurisdictions (D/D outcome).^[3] The application of these hybrid mismatch rules have caused some uncertainty as to their application to countries where there is no tax system (tax neutral jurisdictions). In such a jurisdiction, there is no tax system to include the income.

The Organisation for Economic Co-operation and Development (OECD) has elaborated on how these anti-hybrid rules apply to tax neutral jurisdictions. This article will review application of ATAD II's rules on hybrid financial instruments, as well as payments to a reverse hybrid entity with respect to transactions involving associated enterprises^[4] and tax neutral jurisdictions.^[5]

The OECD as the authority for the interpretation of ATAD II

The EU Council has taken the position that the ATAD Directives should be based on the ‘final reports on the OECD Action Items against BEPS’ and that the EU's anti-hybrid rules should also be ‘consistent with OECD BEPS conclusions’.^[6]

The preamble to ATAD II makes it clear that ‘Member States should use the applicable explanations and examples in the OECD [Base Erosion and Profit Shifting] BEPS report on Action 2 as a source of illustration or interpretation to the extent that they are consistent with the provisions of this Directive and with European Union law’.^[7]

The ATAD II preamble also provides that ‘the definition of hybrid mismatch should only apply where the mismatch outcome is a result of differences in the rules governing the allocation of payments under the laws of the two jurisdictions and a payment should not give rise to a hybrid mismatch that would have arisen in any event due to the tax exempt status of the payee under the laws of any payee jurisdiction’^[8].

The EU Commission, in its report on ATP, identified several ‘channels’ or groupings of ATP structures. It particularly identified a specific ‘mismatch’ channel for hybrid loan and hybrid entity structures, and a separate channel of ATP risk for tax deductible expenses to tax neutral jurisdictions called the ‘offshore loan ATP structure’.^[9]

Similarly, the OECD Hybrid Mismatch Final Report states that ‘the hybrid mismatch rules focus on payments and whether the nature of that payment gives rise to a deduction for the payer and ordinary income for the payee’.^[10] The OECD further clarifies that ‘the only types of mismatches targeted by this report are those that rely on a hybrid element to produce such outcomes’.^[11]

Accordingly, both the EU and the OECD's policy is that the hybrid rules are focused specifically on abusive tax advantages from hybrid treatment. The use of zero or low tax jurisdictions is not the focus of the hybrid rules. In short, the D/NI outcome generally must be the result of a hybrid mismatch. not only because of differences in tax systems or tax status in the payee's jurisdiction (ie, no tax system, territorial tax or tax exempt status).

This report also states that, once a deductible item is includible in the ordinary income in any jurisdiction, the hybrid mismatch rules should no longer be applicable. It even specifically states that ‘if the payment is brought into account as ordinary income in at least one jurisdiction, then there will be no mismatch for the rule to apply to’.^[12]

Still, the question remains of whether a deductible expense paid from an EU Member State can be considered as 'includible income' when the payee is located in a tax neutral jurisdiction, or whether other reasoning may apply for purposes of not applying a D/NI outcome, with respect to payments made to tax neutral jurisdictions.

Use of hybrid financial instruments to a payee in a tax neutral jurisdiction

When addressing D/NI outcomes for hybrid financial instruments,^[13] the OECD states its objective is to prevent ‘hybrid mismatches’ where the deduction is not taken into account in ‘ordinary income’ – which it further defines as ‘those categories of income that are subject to tax at the taxpayer’s full marginal rate and that do not benefit from any exemption, exclusion, credit or other tax relief’ and that ‘under the laws of the payee jurisdiction, the payment is required to be incorporated as ordinary income into a calculation of the payee’s taxable income’.^[14]

This apparent requirement that the item must be included in ‘taxable’ income could cause uncertainty, as how the D/NI outcome rules for hybrid financial instruments would apply to a payee in a tax neutral jurisdiction. However, the OECD Hybrid Mismatch Final Report expressly provides an example. Example 1.6 in the Report describes:

‘A Co (a company resident in Country A) owns all the shares in B Co (a company resident in Country B). A Co lends money to B Co. Additionally, the loan is treated as a debt instrument under the laws of Country B but as an equity instrument (i.e. a share) under the laws of Country A and interest payments on the loan are treated as a deductible expense under Country B law but as dividends under Country A law’.^[15]

In terms of tax systems, Example 1.6 elaborates that Country A (the laws under which A Co is established) does not have a corporate tax system and A Co does not have a taxable presence in any other jurisdiction. A Co is therefore not liable to tax in any jurisdiction on payments of interest under the loan.^[16]

The OECD's guidance on Example 1.6 is that the hybrid financial instrument rule is not applicable because such factual situation is neither giving rise to a ‘mismatch’ nor is ‘within the intended scope of the hybrid financial instrument rule’. The OECD explains that a D/NI outcome results in a mismatch only if the payment is not included in the income of the payee's jurisdiction. In the case where the payee is not a taxpayer in any jurisdiction, ‘there is no payee jurisdiction where the payment can be included in income’.^[17] In other words, since it is not possible to include the item of income in any jurisdiction that has a tax system, no mismatch is possible.

Therefore, this is a clear example provided by the OECD where a deductible payment to an associated enterprise in a tax neutral jurisdiction will not trigger the hybrid financial instrument rule even if the financial instrument itself has hybrid characteristics.^[18]

Reverse hybrid entities and tax neutral investors

Both the Report's Chapter 4 and ATAD II have a ‘reverse hybrid entity’^[19] rule which applies to the extent that a payment to a reverse hybrid entity results in a D/NI outcome when the following conditions are fulfilled:

• the payer is tax opaque and is established in a jurisdiction which considers the payee entity to be transparent for tax purposes (often both the payer and payee are in the same jurisdiction);

• the jurisdiction of the investor considers the payee to be tax opaque; and

• the mismatch would not have arisen had the payment been made directly to the investor.^[20]

In practice, these 'reverse hybrid entity' structures would typically have involved a partnership (payee) entering into an interest bearing loan with a wholly owned company (payer) in the payee's jurisdiction. This would characterise the company paying the interest expense as tax opaque, but the payee (partnership) as tax transparent.^[21] The transparent partnership is then usually owned by investors that also consider the partnership as tax opaque in their own jurisdiction. Such facts result in a D/NI outcome by applying the aforementioned reverse hybrid rule (ie, denying a deduction in the payer jurisdiction, because there is no inclusion in either of the jurisdictions of the payee or the investor).

The OECD consistently states that this reverse hybrid rule will not apply to the extent that ‘the payment is brought into account as ordinary income in at least one jurisdiction’ because ‘there will be no mismatch for the rule to apply to’.^[22] The OECD further clarifies that ‘the most basic example of a transparent person is a trust or partnership’.^[23]

Taking all the above into account, consider the situation where the investor is a company in a tax neutral jurisdiction. While the OECD Hybrid Mismatch Final Report does not contain an example precisely on point here, it does contain Example 4.1 where a tax exempt entity is the investor.^[24]

In this example, the OECD cites that because the investor is tax exempt, ‘the payments here are not caught by the reverse hybrid rule because the mismatch in tax outcomes is not a hybrid mismatch’. The OECD explains that the reverse hybrid rule will not apply unless the payment attributed to the investor would have been included in the ordinary income if the payment had been directly to the investor instead of the reverse hybrid entity. In this example, the investor is a 'tax exempt entity' and so ‘the payment would not have been taxable’ even if paid directly to the investor. Thus, the reverse hybrid rule should not apply to deny the deduction.^[25] Presumably, the same logic would be applicable to an investor in the form of a company in a tax neutral or territorial tax system, because a direct payment to such an investor in a reverse hybrid entity would not have been taxable by a direct payment from the payer.

Conclusion

In conclusion, the EU Council has stated that the OECD Final Hybrid Mismatch Report should be used as a basis for interpreting the complex anti-hybrid rules found in ATAD II. However, these rules are new and there is not yet any case law or jurisprudence demonstrating how any EU Member State would actually interpret their implementation.

Additionally, each EU Member State has the power to create stronger anti-hybrid rules that go beyond the minimum required in ATAD II. Accordingly, caution and prudence are recommended when analysing the outcomes of applying ATAD II's complex rules. especially as how they may be implemented in each EU Member State's own tax laws.

The anti-hybrid rules are certainly not the only anti-abuse ruleset available to EU Member State tax authorities, and so additional analysis for other anti-abuse rules should be taken into account including debt limitation rules, controlled foreign corporation rules, transfer pricing, economic substance, business purpose, and general anti-abuse rules.

 

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