|March 24, 2014|
Previously published on March 21, 2014
The Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) action plan is moving forward. On March 19, 2014, the Organisation for Economic Co-operation and Development (OECD) released two discussion drafts on “action 2” of the OECD’s BEPS action plan (Action 2).
Action 2 is targeted at neutralizing the potential tax advantages, including elimination of taxation, double deduction and long-term deferral, of certain instruments or entities that are treated differently under domestic laws of two countries, so-called “hybrid mismatch arrangements.” A simple example of a hybrid mismatch arrangement is a financial instrument treated as debt giving rise to deductible interest payments in the payor’s country of residence and equity giving rise to exempt dividend income (e.g., because of a participation exemption or dividend-received deduction) in the payee’s country of residence.
The first discussion draft addresses hybrid mismatch arrangements through proposed targeted changes to domestic law. Perhaps, the cleanest way to neutralize hybrid mismatch arrangements would be to harmonize domestic laws such that, in our prior example, both the payor’s country of residence and the payee’s country of residence would either treat the financial instrument at issue as debt or as equity. The first discussion draft did not even consider this possibility—cleaning the Augean stables of every domestic tax regime without a river handy to divert is doubtless too big a task even for the ambitious BEPS action plan.
Instead, the first discussion draft recommends additional domestic law provisions that specifically target hybrid mismatch arrangements by linking the domestic tax treatment of entities, instruments or transfers in one country to the domestic tax treatment in another country. Returning to our simple example, the payor’s ability to deduct interest payments in its country of residence would be dependent on (i.e., “linked”) to the inclusion of such payment as income in the payee’s country of residence. While the first discussion draft concedes that such a system would “make the application of domestic law more complicated,” one might wonder if the approach merely leaves the hard work of international cooperation and effective coordination of domestic laws for implementation, administration and enforcement of any new domestic law provisions.
The propriety of the first discussion draft’s recommendation likely will come into focus as we begin to learn from the experiences of Germany, Austria and Italy that have adopted similar rules. Even so, the approach seems to be gathering some consensus in the international community, including to some extent in the United States where the President’s 2015 annual budget includes a similar provision targeting hybrid mismatch arrangements, albeit only in the context of related parties.
The second discussion draft recommends changes to the OECD Model Tax Convention that effectively looks through certain entities treated as pass throughs under domestic law of a country to determine whether income will be considered income of a resident of such country for treaty purposes.
OECD’s first discussion draft (Neutralise the effects of Hybrid Mismatch Arrangements - Recommendations for Domestic Laws)
OECD’s second discussion draft (Neutralise the effects of Hybrid Mismatch Arrangements - Treaty Aspects of the Work on Action 2 of the BEPS Action Plan)
OECD’s BEPS Action Plan
2015 Green Book