On 19 March 2014, the OECD released two public discussion drafts on the development of model treaty provisions and recommendations for the design of domestic rules to neutralize the effect of hybrid mismatch arrangements, as part of its base erosion and profit-shifting action plan (BEPS project) announced last July (Action 2). According to the OECD, hybrid mismatch arrangements can be used to achieve unintended double non-taxation or long-term tax deferral by, for instance, creating two deductions for one borrowing, generating deductions without corresponding income inclusions, or misusing foreign tax credit and participation exemption regimes.
The first discussion draft (domestic laws)
The first discussion draft sets out recommendations for domestic rules to neutralize the effect of hybrid mismatch arrangements. It includes the following categories and recommendations.
- Hybrid instruments
a) Jurisdictions should deny a deduction for any payment made under a hybrid financial instrument to the extent that the payee does not include the payment as ordinary income under the laws of any jurisdiction.
b) Jurisdictions should require a payee to include any payment made under a hybrid financial instrument as ordinary income to the extent that the payer is entitled to claim a deduction for such payment and the payer’s jurisdiction does not apply a hybrid mismatch rule in accordance with recommendation (a) above.
c) A dividend exemption should not be granted under domestic law to the extent it is a deductible payment in another jurisdiction so that, in these situations, no mismatch will arise. This is in line with the recently proposed changes to the EU Parent-Subsidiary Directive.
- Hybrid entities
The discussion draft recommends changes to domestic law to address the different characterization of payments made by entities resulting from the differences in the tax treatment of those entities. It remedies both double deduction structures and deduction/no inclusion structures. The discussion draft only focuses on whether the payment gives rise to a deduction in the subsidiary jurisdiction that could be offset against income which is not subject to tax in both jurisdictions (i.e. dual inclusion income). It would need to be applied only in one jurisdiction rather than both.
- Imported mismatches (including reverse hybrids)
The discussion draft also addresses imported mismatch arrangements, which are hybrid structures created under the laws of two jurisdictions where the effects of the hybrid mismatch are imported into a third jurisdiction.
The second discussion draft (treaty issues)
The second discussion draft discusses the interaction of the OECD Model Treaty with domestic rules in the context of hybrid arrangements and sets out recommendations for further changes to the OECD Model Treaty and Commentary to clarify the treatment of hybrid entities. The discussion draft includes proposals with regard to mismatches between domestic and treaty concepts of corporate residence, limitation of treaty benefits for certain transparent entities where neither Contracting State treats, under its domestic law, the income of an entity or arrangement as the income of one of its residents, and double taxation relief in the case of hybrid dividend payments.
The OECD invites interested parties to send comments on this discussion draft by 2 May 2014 at the latest.