Action Plan 2 – Neutralize the effects of Hybrid Mismatch Arrangements - International Taxation - Income Tax

Action Plan 2 Neutralize the effects of Hybrid Mismatch Arrangements Meaning of Hybrid Mismatch Arrangements: A hybrid mismatch is an arrangement that: Hybrid mismatch arrangements are sometimes used to achieve unintended double non taxation or long term tax deferral in one or more of the following ways A hybrid transfer includes any arrangement to transfer a financial instrument entered into by a taxpayer with another person where: the taxpayer is the owner of the transferred asset and the rights of the counterparty in respect of that asset are treated as obligations of the taxpayer; and under the laws of the counterparty jurisdiction, the counterparty is the owner of the transferred asset and the rights of the taxpayer in respect of that asset are treated as obligations of the counterparty. Ownership of an asset for these purposes includes any rules that result in the taxpayer being taxed as the owner of the corresponding cash-flows from the asset. 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 such financing or equity return. Any payment under an arrangement that is not treated as a financial instrument under the laws of the counterparty jurisdiction shall be treated as giving rise to a mismatch only to the extent the payment constitutes a financing or equity return. Action 2 calls for the development of model treaty provisions and recommendations regarding the design of domestic rules to neutralise 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. Recommended general amendments are as follows- A rule denying transparency to entities where the non-resident investors resident country treats the entity as opaque; A rule denying an exemption or credit for foreign underlying tax for dividends that are deductible by the payer; A rule denying a foreign tax credit for withholding tax where the tax is also credited to some other entities; and Amendments to CFC and similar regimes attributing local sharholders the income of foreign entities that are treated as transparent under their local laws. The recommended primary rule is that countries deny the taxpayer s deduction for a payment to the extent that it is not included in the taxable income of the recipient in the counterparty jurisdiction or it is also deductible in the counterparty jurisdiction. If the primary rule is not applied, then the counterparty jurisdiction can generally apply a defensive rule, requiring the deductible payment to be included in income or denying the duplicate deduction depending on the nature of the mismatch. Treaty Changes Action Plan 2 recommends a new provision in the case of income earned by a transparent entity. As per the new provision, treaty benefits will only be afforded to so much of the income of the entity as the income of a resident of that state. A specific or general saving rule is proposed so that a State can tax a resident entity generally unrestricted by treaty. Anti-hybrid rules The report further a series of dedicated domestic anti-hybrid rules which would work in two stages. The primary rules would deny deductions to payers in situations where either- Those payments will not be included in the receipient s ordinary income. Or The same amount is being simultaneously deducted by another entity. The examples in the 2015 Final Report demonstrate these outcomes (deduction and non-inclusion, or double deduction) arising from various hybrid financial instruments, financing transactions and under entity recognition and de-recognition rules. The report also addresses banks and insurance companies wherein it recommends that there should be targeted rules addressing base erosion and profit shifting in such sectors. The basic rules might not work for them because they will typically have net interest income. Treatment of Branch Mismatches 2017 Report 1. Branch mismatches arise where the ordinary rules for allocating income and expenditure between the branch and head office result in a portion of the net income of the taxpayer escaping the charge to taxation in both the branch and residence jurisdiction. Unlike hybrid mismatches, which result from conflicts in the legal treatment of entities or instruments, branch mismatches are the result of differences in the way the branch and head office account for a payment made by or to the branch. Because branch mismatches turn on differences in tax accounting rather than legal characterisation, the same basic legal structure may call for the application of different branch mismatch rules, depending on the accounting treatment adopted by the branch and head office. 2. This report identifies five basic types of branch mismatch arrangements: disregarded branch structures where the branch does not give rise to a permanent establishment (PE) or other taxable presence in the branch jurisdiction diverted branch payments where the branch jurisdiction recognises the existence of the branch but the payment made to the branch is treated by the branch jurisdiction as attributable to the head office, while the residence jurisdiction exempts the payment from taxation on the grounds that the payment was made to the branch deemed branch payments where the branch is treated as making a notional payment which results in a mismatch in tax outcomes under the laws of the residence and branch jurisdictions DD branch payments where the same item of expenditure gives rise to a deduction under the laws of both the residence and branch jurisdictions imported branch mismatches where the payee offsets the income from a deductible payment against a deduction arising under a branch mismatch arrangement. Branch mismatches rules can arise directly as well as indirectly through a taxpayer s investment through a transparent structure such as a partnership.