On October 25, 2016, the EU Commission issued a new proposal targeting several types of hybrid mismatches taking place within the European Union but also involving third countries (the "Proposal"). When adopted, this Proposal amending the existing Anti-Tax Avoidance Directive ("ATAD") will require member states of the European Union, among other things, to deny deductions or include revenues in the taxable basis of the relevant taxpayer to fight against those mismatches. You should keep an eye on your hybrid financial instruments, repo's and securities lending transactions (as well as many other transactions), as they might be at stake.

I. Context

The ATAD was issued on July 12, 2016, and lays down rules against schemes used by taxpayers aiming at taking advantage of disparities between national tax systems in order to reduce their tax liability and that are against the actual purpose of the law. The ATAD responds to the Base Erosion and Profit Shifting ("BEPS") project in adopting a coordinated EU approach against corporate tax abuse.

In particular, the ATAD contains rules to address the most widespread forms of hybrid mismatch arrangements, but only within the European Union.

The BEPS project was adopted in October 2015 by the Organization for Economic Co-operation and Development ("OECD") in order to combat aggressive tax planning techniques used by taxpayers to exploit loopholes in tax systems and mismatches between national rules to artificially shift profits to low or no-tax locations, where there is little or no economic activity, and to reduce their tax liabilities ("BEPS Structures").

Action 2 targets hybrid mismatch arrangements (the "OECD Report").

As it is clear that taxpayers also use hybrid mismatch arrangements with third countries in order to reduce their tax liability, the ECOFIN Council requested, in its statement of June 20, 2016, that the Commission put forward by October 2016 a proposal on hybrid mismatches involving third countries in order to provide for rules consistent with, and no less effective than, the rules recommended by the OECD Report. The assumption was to reach an agreement by the end of 2016. The Proposal is the response to the ECOFIN' s request.

The Proposal shall be adopted by the member states by December 31, 2018, at the latest and shall be applied as of January 1, 2019.

II. Hybrid Mismatches at Stake

The hybrid mismatches targeted by the Proposal are the ones deriving from a situation between a taxpayer and an associated enterprise or a structured arrangement between parties in different tax jurisdictions.

The ATAD already covers the most common forms of hybrid mismatch arrangements within the European Union, namely hybrid entity and hybrid financial instrument mismatches:

  • Hybrid entity mismatch occurs if an entity is treated as transparent for tax purposes by one jurisdiction and as non-transparent by another jurisdiction, leading to a double deduction of the same payment, expenses or losses or to a deduction of a payment without a corresponding inclusion of that payment.
  • Hybrid financial instrument mismatch occurs if the tax treatment of a financial instrument differs between two jurisdictions, leading to a deduction of a payment from the taxable base of the payer without an inclusion of that payment in the taxable base of the recipient.

The Proposal now targets hybrid entity and hybrid financial instrument mismatches involving third countries.

The Proposal also extends the ATAD application to other types of mismatches (in their intra-EU and third-country dimension) not yet covered by the ATAD, such as hybrid permanent establishment mismatches, hybrid transfers, imported mismatches and dual resident mismatches:

  • Hybrid permanent establishment mismatch, which occurs where the business activities in a jurisdiction are treated as being carried on through a permanent establishment by one jurisdiction, while those activities are not treated as being carried on through a permanent establishment by another jurisdiction. This leads to a non-taxation without inclusion, to a double deduction or to a deduction without inclusion.
  • Hybrid transfer, which is an arrangement to transfer a financial instrument where the laws of two jurisdictions differ on whether the transferor or the transferee possesses the ownership of the payments on the underlying asset. This leads to a deduction without inclusion.
  • Imported mismatch, which arises from arrangements shifting the effect of a hybrid mismatch between parties in third countries into the jurisdiction of a member state through the use of a non-hybrid instrument. A mismatch is imported in a member state if a deductible payment under a non-hybrid instrument is used to fund expenditure under a structured arrangement involving a hybrid mismatch between third countries (implying a flow of revenue out of the European Union eventually not being taxed), leading to a deduction in a member state accompanied by a double deduction or a deduction without inclusion between third countries.
  • Dual resident mismatch, where a dual resident taxpayer makes a payment deducted under the laws of both jurisdictions where the taxpayer is resident, which may lead to a double deduction.

When one of the above is identified, the Proposal requires the relevant member state to deny the deduction of the payment concerned or to include such payment in the taxable basis of the taxpayer.

Further, and this might be very relevant for current tax planning structures, the Proposal states that timing differences resulting from the use by jurisdictions of different tax accounting periods and different rules for recognizing when items of income/expenditure have been derived/incurred should not be treated as giving rise to mismatches in tax outcomes. However, if such timing differences occur, the payer should ensure that the payment is recognized within a reasonable period of time in the payee's jurisdiction (as otherwise the ATAD shall apply).

III. Tax Planning Structures in the Hot Seat

A. Hybrid Financial Instruments

At first sight, some common hybrid financial instruments might be affected, such as PEC, MRPS, debt instruments stapled with an equity instrument and the redemption of convertible debt instruments.

Indeed, an EU payer under a hybrid instrument (with a payee located in a third country, e.g., the United States) allowing deduction in the payer's jurisdiction (e.g., PEC, MRPS) may have its payment deduction denied by the MS where it is located if such payment is not included in the taxable basis of the payee's jurisdiction (but probably not in case of the sole inclusion's deferral).

Moreover, an EU parent recipient of revenues from an EU subsidiary deriving from a debt instrument stapled with an equity instrument might be concerned as well. If the interest received under the debt instrument benefits from an exemption in the recipient state (because it is regarded as a dividend, e.g., in Luxembourg) and from a deduction in the subsidiary state, the member state of the receiving entity may have to include in the taxable basis of the parent any income that is deductible in the subsidiary member state.

In the case of an EU issuer (e.g., Luxembourg) that would redeem a convertible debt instrument at fair market value and benefit from a deduction in its jurisdiction (e.g., Luxembourg),the issuer member state should deny the deduction if there is no inclusion of revenue at the parent level.

Proposal's consequences on hybrid financial instruments in a nutshell:

Intra-EU Situations

Payee in Third Country

Payer in Third Country

Double Deduction

Deny payee deduction

Deduction denied by the MS, unless already done by third country

Deduction denied by the MS, unless already done by third country

Deduction Without Inclusion

Deny payer deduction

Deduction denied by MS

Payment must be included in the taxable basis of the payee, unless deduction already denied by third country or payment already included

B. Repo's and Securities Lending Transactions

Structures using such features would typically rely on a payment connected with the underlying return on the transferred instrument and regarded as a deductible expense by one jurisdiction and as a tax exempt return on the underlying asset by another jurisdiction. This leads to a deduction without inclusion, and therefore the deduction might be denied in the future.

Securities lending transactions could come under great scrutiny as well. They may lead to situations where different taxpayers resident in different tax jurisdictions may claim withholding tax credits on the same income. This situation is addressed by the ATAD by limiting the amount of the credit in proportion to the taxpayer's net income under the arrangement.

C. Check-the-Box Rules

The Proposal makes clear that the ATAD targets hybrid mismatches arising from differences in the legal characterization of an entity or a financial instrument when this legal characterization relates to the qualification of an entity or financial instrument for tax law purposes. Therefore, tax arrangements using the US Check-the-Box Rules in order to take advantage of differences in the classification of an entity as transparent or not in multiple jurisdictions and leading to a deduction in one jurisdiction without inclusion in the other jurisdiction might be tackled as well. In such situations involving a third country and a member state, the member state of the payer or the payee might deny the deduction or include the payment in the taxable base of the taxpayer, as the case may be.