On 29 May 2017, the Council of the European Union adopted a second Anti-Tax Avoidance Directive ("ATAD II"). ATAD II replaces the hybrid mismatch provisions of the Anti-Tax Avoidance Directive no. 2016/1164 ("ATAD I"), which was adopted on 12 July 2016. ATAD II expands the scope of the hybrid mismatch provisions to third countries and other forms of hybrid mismatches. Member States of the European Union are required to transpose the provisions of ATAD II into their national laws by 1 January 2020. Provisions with respect to reverse hybrid mismatches must be transposed by 1 January 2022. Hybrid mismatches that are already covered by the EU Parent Subsidiary Directive are outside the scope of ATAD I and ATAD II. Background ATAD I introduced several anti-tax avoidance measures, including an interest deduction limitation rule, a controlled foreign company rule, a general anti-abuse rule, exit taxation rules and provisions countering intra-EU hybrid mismatches Read more about this in our previous client alert. As ATAD I did not cover hybrid mismatches with third countries, the European Commission was requested to expand the neutralization of hybrid mismatches to third countries, consistent with the rules recommended by the OECD BEPS Action 2 report. Initial anti-hybrid rules ATAD I covered hybrid mismatches resulting from a different characterization of a financial instrument or entity between the EU Member State of the taxpayer and an associated enterprise (50% of the voting and/or capital) in another EU Member State. ATAD I only covered mismatches resulting from a difference in characterization of an instrument or entity that arose between associated enterprises. The solution for a double deduction of the same payment was to only allow the deduction in the source country of the payment. The solution for a payment without inclusion was to deny the deduction of the payment. New anti-hybrid rules ATAD II replaces the hybrid mismatch provisions of ATAD I and expands the scope to several other hybrid mismatches (see below) and to third countries. The new provisions of ATAD II mainly cover the following types of hybrid mismatch situations: Double deduction - To the extent a hybrid mismatch results in a double deduction, the deduction shall be denied in the EU Member State that is the investor country. If the deduction is not denied in the investor jurisdiction, the deduction shall be denied in the EU Member State that is the payer country. For example, if State A (investor country) treats a subsidiary (resident in EU Member State B) as transparent, whereas State B considers such entity non-transparent, interest paid by B may be deductible in State A as well as State B. Under the new rules, State A should deny the deduction. If State A is a third country that does not deny the deduction, State B (as an EU Member State) should deny the deduction. Deduction without inclusion - To the extent a hybrid mismatch results in a deduction without inclusion, the deduction shall be denied in the payer jurisdiction. If the deduction is not denied in the payer jurisdiction, the income corresponding to the mismatch shall be included in the payee jurisdiction. For example, if an EU Member State allows a deduction for a payment on a financial instrument that is characterized differently in the other country, and the payment is not included in the income within a reasonable period of time, the EU Member State should deny the deduction. EU Member States may exclude certain financial instruments issued with the sole purpose of satisfying loss-absorbing capacity requirements applicable to banks from the scope of these rules until 31 December 2022. Another example would be where a deductible payment is made by a permanent establishment (PE) to its head office in an EU Member State. If the head office does not recognize the internal transaction and thus does not tax the income, the PE country must deny the deduction. If the PE country is located in a third country that allows the deduction, the head office in the EU Member State must include the income. Moreover, if neither the head office nor the PE includes a payment received in its taxable income (the head office country regards it as PE income, and the PE country regards it as head office income), the payer country — if in an EU Member State — should deny the deduction. As from 1 January 2022, a special rule for reverse hybrid entities will become effective. A reverse hybrid is an entity that is treated as transparent in the Member State where it is established and as non-transparent in the country of its investor. According to this rule, the EU Member State in which the entity is established will be required to tax its income to the extent the income is not otherwise taxed in that Member State or in any other jurisdiction. Imported hybrid mismatches - If a hybrid mismatch arises between two entities in third countries, but that mismatch is effectively "imported" into an EU Member State by a non-hybrid instrument or entity, the deduction of the related payment shall be denied by the EU Member State of which the paying entity is a resident, unless one of the third countries involved has made an equivalent adjustment. For example, if two entities in third countries enter into a hybrid instrument resulting in deduction without inclusion (see above) and subsequently a non-hybrid loan is granted to an entity in an EU Member State, the interest paid by that EU entity is generally non-deductible under this provision, unless (one of) the third countries already neutralize(s) the hybrid mismatch. Dual resident mismatches - If a paying entity is considered to be a tax resident of two countries and the payment is deductible from the tax base in both countries, and only one of them is an EU Member State, the EU Member State shall deny the deduction of the payment to the extent that the payment in the third country can be offset against income that is not also taxable income in the EU Member State. If both countries are EU Member States, the EU Member State where the taxpayer is not deemed to be a resident according to an applicable treaty shall deny the deduction. Disregarded PE - This provision covers the situation where the head office country recognizes a PE in another country, while no such PE is recognized in that other country. To the extent a hybrid mismatch involves disregarded PE income, the EU Member State in which the taxpayer resides shall require it to include the income that would otherwise be attributed to the disregarded PE. An exception may apply if the tax treaty forces the EU Member State to exempt the PE income. Hybrid Transfers - To the extent a hybrid transfer provides relief for tax withheld at source on a payment to more than one party involved, the EU Member State of the taxpayer shall limit the benefit of such relief in proportion to the net taxable income regarding such payment. For example, if shares or bonds are temporarily transferred to another party, and the country of both the transferor and transferee regard each party as the owner of the instrument, both countries may grant relief of double taxation for dividends or interest received. If the transferee is obliged to pay the return to the transferor (security lending), the country of the transferee should limit the tax credit. What's Next? EU Member States are obliged to implement ATAD II in their national laws and the rules should become effective by 1 January 2020 (or later for specific provisions referred to above). It should be noted that, except for the measures relating to hybrid mismatches, the other measures prescribed by ATAD I (see Background above) must in principle be implemented by all EU Member States by 1 January 2019. Certain EU Member States have already introduced part or all of the above anti-hybrid mismatch provisions in their national laws, and others may decide to introduce these prior to 1 January 2020. Therefore, we recommend liaising with your tax adviser to analyze the potential impact of the EU anti-hybrid mismatch rules for your group and, where needed, taking timely action to avoid adverse tax consequences. We would be pleased to assist you with this.
This Tax Alert has been prepared for general information purposes only. The information presented is not legal advice, is not to be acted on as such, and may be subject to change without notice.