Tax effects of hybrid arrangements

As the world progresses and becomes more complex, the general evolution does not necessarily imply the evolution of all the factors that make up the context. For example, the advancement of technology to improve communications and trade led to an involution of the world’s tax systems, which in relation to certain aspects – e.g.: control of international operations and the digital economy – have become obsolete, or less efficient and effective.

While in many countries-not only those belonging to developing economies – significant tax compliance problems remain at internal level, problems occurring at the international level are widespread and become more sophisticated and harmful. It is precisely in this last area that the international tax community has decided to invest substantial resources to search for solutions.

With the political support of the G20, the OECD has developed the BEPS Action Plan, which, regardless of what may be said about the recommendations, constitutes one of the greatest opportunities that the tax world has to understand the way multinational groups or global taxpayers carry out their tax planning and as a result, the problems arising from their behavior.

I’m going to focus on the problem raised in the action 2 of the BEPS Action Plan, in particular on the effects of hybrid arrangements, a topic also referred to in the Action Plan issued by the European Commission in December 2012[1].

A reference to biology can be useful to understand the concept of “hybrid” where “…a hybrid is the living organism, plant or animal from the intersection of two organisms of distinct subspecies, species, or races…” From the point of view of taxation, a “hybrid” exists when two countries consider the same basic aspect of the income tax[2] in a different way, while both assess a same transaction. The structural problem occurs when mixing the tax bases of the source and the residence country. However, it is to note that not all hybrid arrangements effectively generate mismatches.

In certain cases, the different tax treatments by countries have not resulted in inconsistencies. International experience shows that the effects of hybrid arrangements often benefit the taxpayer and not necessarily generate double taxation. This is no coincidence, and this is the result of the tax planning of taxpayers, based on a situation where two countries are not in agreement about which category corresponds a certain income. Put another way, hybrids are a means that tax planners may use two countries with tax systems considered as normal and decent, to then produce mismatches with effects comparable to those used by tax havens to channel investment. It is also possible that some countries may be tempted to create this type of opportunities – hybrids – to generate an economic impact approaching that of a tax exemption or concession which could attract foreign investment.

Such imbalances between the treatments granted by standards in each of the countries involved-giving allow global subjects to obtain one tax burden lower than the one of smaller companies operating domestically, with which these multinationals compete. One of the major risk factors facing the countries lies in the fact that, while the behavior of the taxpayers who use hybrids is not right, from the regulatory point of view it could be considered acceptable, since this issue belongs to the field of tax avoidance.

The topic presents a high complexity, even more considering the level of development of many countries in the world in the field of international taxation. Such complexity is also perceived in its terminology. For instance, the literature on hybrids was originally conceived in English, and some terms are not translated clearly enough. The title of the action 2 in English is Neutralizing effects of hybrid mismatch arrangements, while in Spanish, according to the official translation of the OECD, would be to “Neutralizar los Efectos de los Mecanismos Híbridos”. We must, for example, consider the term “arrangement” which appears numerous times over more than 400 pages generated in the framework of the respective action. Consulting online dictionaries, we could reach the conclusion that arrangement means a “disposición”, “acuerdo”, “arreglo” or even “plan”. However, the OECD uses the term “mecanismo” on their official translations. The complexity of the issue does not end with this example. It also lies in the lack of a single definition of “hybrid mismatches”. From the recommendations 1, 3, 4, 6 and 7 of the action 2, different definitions emerge.

Action 2 of the BEPS Action Plan is divided into two parts. The first one presents three categories of hybrid arrangements, according to their effect on taxation:

• Deduction-No inclusion: occurs when the payment made by a taxpayer creates a deductible expense while the receipt of this payment does not generate a taxable revenue on the side of the receiver.
• Double deduction: occurs when a particular payment is considered deductible in more than one jurisdiction.
• Deduction-Indirect No-inclusion: occurs when a “non-hybrid” payment made by a third jurisdiction, is compensated by a deduction generated by a ‘hybrid’ payment from the jurisdiction receiving the payment made by the third party. When the “hybrid effect” proceeds from an intermediary jurisdiction, this case is called “imported hybrid”.

In each of the categories concerned, up to six types of differentiated hybrid arrangements are identified, which are the subject of the first eight recommendations contained in the first part of Action 2. The recommendations adopt a common structure, consisting of a primary rule, which provides that a country denies taxpayers the ability to deduct a payment in so far as it is not included in the taxable income of the beneficiary or income subject to taxation in the jurisdiction of the counterparty, or when it is also deductible in the latter. If this primary rule is not applied, the counterparty jurisdiction can apply a secondary rule or defensive, based on which the deductible payment must be reflected within the revenue or its double deduction must be prevented according to the nature of the asymmetry. Also, the document refers to the application scope of the recommendation.

Furthermore, recommendations 9 to 12 include guidelines for a better transposition of the rules proposed into the internal laws of States, as well as definitions of the terms used throughout the final report.

The second part of the report of the aforementioned action 2 includes three chapters intended to prevent the use of institutions and hybrid structures or institutions with dual residence for the undue benefit of the provisions of the conventions to avoid double taxation. It also analyzes alternatives to ensure that existing conventions do not adversely affect the implementation of modifications to the internal normative recommended in part I.

The mentioned action 2 only focuses on hybrid instruments and hybrid entities. For example, it does not address differences that may occur on interpretations concerning the moment at which a payment generates the tax liability. As countries go assimilating these developments, it would be necessary to move forward on other categories.

Because of its size, the post has been divided into two parts. We invite you to read part II, which includes case studies  and some reflections and will be published on May 23.

Consulted texts:

United Nations handbook on Selected Issues in Protecting the Tax base of Developing Countries. 2015.

Project OECD/G20 on the tax base erosion and profits shifting. Final Reports 2015. Abstracts.

Action 2: neutralize the effects of hybrid arrangements. Tax and competitiveness Foundation. 2017.

BEPS.

Principales implicados para el sector financiero. Ernst & Young. 2015.

[1] In 2012 the European Commission launched a public consultation on situations of double non-taxation, which referred to the “hybrids”. “Communication from the Commission to the European Parliament and the Council.” “An Action Plan to strengthen the fight against tax fraud and tax evasion“. December 6, 2012. COM (2012) 722 final.

[2] There are three essential aspects included in that all income tax: persons, income and income-generating activities. Each of them shows a number of basic features that the standard should detail.

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