Dealing with OECD’s “Neutralizing the effects of hybrid mismatch arrangements” (BEPS Action #2).


Qualification mismatches can be powerful tools to reduce tax costs in MNC’s tax planning structures. How the OECD proposes to neutralize the effects of hybrid mismatch arrangements may/will impact MNC’s.  What does this mean for business? What should MNC’s do? This paper provides a technical summary.


The OECD, with the backing of the G20, published a 15 points action plan in July 2013 setting out proposals to address base erosion and profit shifting (BEPS). The project has developed in response to concerns that the interaction between various domestic tax systems and double tax treaties can often lead to profits falling outside the charge to tax altogether or be subject to an unduly low rate of tax. The OECD published its final BEPS package in October 2015.


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By Norbert Braspenning

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Within international tax law, different interpretation of an investment, debt or equity under the laws of two or more tax jurisdictions is called a “hybrid-mismatch”. This can lead to double taxation or double non-taxation.

“Hybrid-mismatch”: two or more tax jurisdictions interpret the same instrument differently.

 “Hybrid-mismatch-arrangements”: arrangements that make use of “Hybrid-mismatches”.

These mismatches can be powerful tools to reduce tax costs in a tax planning structure as they make use of differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral. Though legal, this is of a concern to the OECD.

“Hybrid-mismatch-arrangements” are arrangements intended to secure these tax advantages (mismatches) within multinational groups resulting from differences in tax treatment of the same instrument or entity between different jurisdictions. Hybrid mismatch arrangements can arise both from “hybrid financial instruments” and “hybrid entities”. These types of arrangements are widespread and result in a substantial erosion of the taxable bases of the countries concerned. They have an overall negative impact on competition, efficiency, transparency and fairness. Therefore these strategies are cause for concern for countries. As such, they are high on the list of priorities for the BEPS project.

Hybrid entity: a multinational company subject to corporate income tax in one national jurisdiction that qualifies for tax transparent treatment in another (resulting in significant tax savings).

Hybrid financial instrument: as any financing arrangement that is subject to different tax characterization under the laws of two or more jurisdictions (resulting in a mismatch in tax treatment).

The two principal mismatches identified are, first, payments which are deductible on the rules of the payer and are not included in the income of the recipient, also referred to as ‘deduction and no inclusion’ outcomes. And secondly, payments which give rise to double deduction of the same expense, also referred to as double deductions.

What is proposed? (BEPS Action point #2)

With a view to increasing the coherence of corporate income taxation at the international level, the BEPS Project called for two recommendations aimed at neutralizing the tax effects of hybrid mismatch arrangements. In this respect the OECD published two discussion drafts in March 2014, followed by a recommendation and a final report in September of that year. In general the OECD recommends;

  1. that countries introduce domestic tax rules to neutralize the impact of arrangements involving hybrid instruments or entities: “Domestic Rules”.
  2.  changes to the OECD Model Tax Convention to address tax mismatches arising from: dual resident entities and transparent entities: “Model Tax Convention Changes”.

See footnote 1 for a more detailed outline of 1. and 2.

Once translated into domestic and treaty law, these recommendations will neutralize hybrid mismatches, by putting an end to multiple deductions for a single expense, deductions without corresponding taxation or the generation of multiple foreign tax credits for one amount of foreign tax paid. By neutralizing the mismatch in tax outcomes, the rules will prevent these arrangements from being used as a tool for BEPS without adversely impacting cross-border trade and investment.

Domestic rules (BEPS Project Recommendation #1)

In respect to domestic tax rules, the OECD recognizes the following three types of hybrid mismatches arrangements for BEPS:

1) Hybrid financial instruments, including transfers. A primary example of this is a financial instrument, the payment on which is deductible as debt in one taxing jurisdiction and taxed as a dividend distribution in another taxing jurisdiction. The mismatch resulting from hybrid financial instruments and transfers leads to D/NI (deduction/no inclusion) outcomes.

OECD’s recommendations: Primary rule: deny a deduction to the extent a payment is not taxed under the recipient’s rules at ordinary rates. Secondary rule: require that the recipient be taxed at ordinary rates with respect to payments which give rise to a deduction to the payer.

2) Hybrid entity payments. Key is the difference in the characterization of a hybrid entity payer resulting in a deductible payment being not taxed as ordinary income or triggering a second deduction in another jurisdiction. Hybrid entity payments can give rise to DD (double deduction) or D/NI (deduction/no inclusion) outcomes.

OECD’s recommendations: Primary rule: deny a deduction for the payment at the level of the owner of a hybrid entity to the extent it exceeds the dual inclusion income of the hybrid entity owner. Secondary rule: require that the recipient recognize income to the extent that the disregarded payment generates deductions in excess of the hybrid entity jurisdiction’s consolidated dual inclusion income earned.

3a) Imported mismatches. This is either an entity hybrid or financing hybrid structure created under the laws of two jurisdictions whereby the effect of a hybrid mismatch that arises between two jurisdictions can be shifted (or imported) into another (third) jurisdiction through the use of a plain-vanilla financial instrument.

3b) Reverse hybrids. These are transparent under the laws of the jurisdiction in which the reverse hybrid (intermediary) is established, and regarded under the laws of the owner/investor of the reverse hybrid. This results in payments being excluded from being taxed as ordinary income in both the intermediary and investor jurisdictions. For example payments to reverse hybrid entities can result in D/NI outcomes when a deductible payment is received by a reverse hybrid and neither the reverse hybrid’s taxing jurisdiction nor its owner’s/investor’s taxing jurisdictions impose tax on the payment.

OECD’s recommendations Primary rule: investor jurisdiction includes the income received by a reverse hybrid (for example, through CFC rules). Secondary rule: if the owner’s/investor’s jurisdiction does not subject the income to tax, the intermediary company (for example, a reverse hybrid receiving a payment) should be taxed in its jurisdiction. Defensive rule: deny a deduction in the payer jurisdiction to the extent the intermediary company does not tax the payment.

Changes to Model Tax Convention (BEPS Project Recommendation #2)

The BEPS Action Plan also highlighted the need for changes to the provisions of the OECD Model Tax Convention. Specifically adding a specific anti-abuse provision to ensure that benefits of tax treaties shall not be granted where none of the treaty partners treats income of an entity as income of one of its residents under its domestic law. In other words, ensure that hybrid instruments and entities are not used to obtain the benefits of treaties unduly. In those cases where no treaty is involved, solutions for these concerns need to be found in domestic laws.

The report contains an extensive analysis of the application of treaty provisions to partnerships, including in situations where there is a mismatch in the tax treatment of the partnership. The main conclusions of the Partnership Report, which have been included in the Commentary of the OECD  Model  Tax  Convention (OECD, 2014), seek to ensure that the provisions of tax treaties produce appropriate results when applied to partnerships, in particular in the case of a partnership that constitutes a hybrid entity.

Recommendations address Dual-resident entities, Treaty provision on transparent entities Interaction between domestic rules and tax treaties (Rule providing for the denial of deductions, Defensive rule requiring the inclusion of a payment in ordinary income, Exemption method, Credit method, Potential application of anti-discrimination provisions in the OECD Model Convention).

See footnote 2 for a more detailed outline of the analysis

What does this mean for business?

The OECD recommendations, particularly those for imported mismatches and reverse hybrids, are complex. The impact will depend on which countries implement these recommendations, as well as the precise wording of the legislation and the timing of implementation. The tax-planning of many MNC’s includes arrangements involving hybrid entities or instruments, including entities that are disregarded for (for example) US tax purposes. The tax treatment of these arrangements may be impacted by these proposals. However, the wide drafting and absence of a motive test means that there is also potential for the rules to apply more broadly than might be expected.

What should MNC’s do?

In due course MNC’s should review the impact of the hybrid mismatch rules on their current arrangements and consider the feasibility of potential alternatives. In any review of their arrangements it will also be necessary to consider the other BEPS proposals including those under Action #3 (CFC), Action #4 (interest deductibility) and Action #6 (prevention of treaty abuse).

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Footnote 1.

Action  #2  calls  for  the  development  of  “model  treaty  provisions”  and recommendations regarding the design of domestic rules to neutralize the effects of hybrid instruments and entities.” The Action Item states that this may include:

  • Changes to the OECD Model Tax Convention to ensure that hybrid instruments and entities (as well as dual resident entities) are not used to obtain the benefits of treaties unduly;
  • Domestic law provisions that prevent exemption or non-recognition for payments that are deductible by the payer;
  • Domestic law provisions that deny a deduction for a payment that is not includible in income by the recipient (and is not subject to taxation under CFC or similar rules);
  • Domestic law provisions that deny a deduction for a payment that is also deductible in another jurisdiction; and
  • Where necessary, guidance on co-ordination or tie-breaker rules if more than one country seeks to apply such rules to a transaction or structure.

Footnote 2.

The OECD report,

  • deals with the application of tax treaties to hybrid entities, i.e. entities that are not treated as taxpayers by either or both States that have entered into a tax treaty (such as partnerships in many countries). The report proposes to include in the OECD Model Tax Convention (OECD, 2010) a new provision and detailed commentary that will ensure that benefits of tax treaties are granted in appropriate cases to the income of these entities but also that these benefits are not granted where neither State treats, under its domestic law, the income of such an entity as the income of one of its residents.
  • examines treaty issues related to rules that would result in the denial of a deduction or would require the inclusion of a payment in ordinary income and concludes that tax treaties would generally not prevent the application of these rules.
  • examines the impact of the recommendations of “Recommendations for domestic law“ with respect to tax treaty rules related to the elimination of double taxation and notes that problems could arise in the case of bilateral tax treaties that provide for the application of the exemption method with respect to dividends received from foreign companies. The report describes possible treaty changes that would address these problems.
  • examines the possible impact of tax treaty rules concerning non-discrimination on the recommendations of “Recommendations for domestic law“; the report concludes that, as long as the domestic rules that will be drafted to implement these recommendations are  properly  worded,  there  should  be  no  conflict  with  these  non-discrimination provisions.