BEPS Action 2 – Hybrid Mismatch Arrangements

BEPS Action 2 “Neutralizing the effect of hybrid mismatch arrangements” aims to neutralise the effects of hybrid mismatch arrangements. The OECD intends to do this by making changes to the model tax convention and providing recommendations on the design of domestic rules to prevent hybrids from being a source of “double non-taxation” (through exploiting differences in the way that jurisdictions treat certain entities or instruments for tax purposes).

Part I of the Final Report on Action 2 contains recommendations on domestic law rules to address hybrid mismatch arrangements.
The recommendations in Part I include hybrid mismatch rules.  The hybrid rules are linking rules aimed at neutralizing one of the following three mismatches in tax outcomes arising out of certain hybrid mismatch arrangements:

  • Payments that give rise to a deduction with no taxable inclusion arising from a hybrid financial instrument (including a hybrid transfer), a disregarded payment made by a hybrid entity or a payment made to a reverse hybrid;
  • Payments that give rise to a double deduction arising from a deductible payment made by a hybrid entity or a dual resident; and
  • Payments that give rise to an indirect deduction with no inclusion arising from an imported mismatch.

Part I of the Final Report includes guidance and comments on:

  • The treatment of stock lending and sale and repurchase transactions;
  • How to treat a payment that is included under a CFC regime;
  • The operation of the imported mismatch rule; and
  • The treatment of hybrid regulatory capital under the hybrid financial instrument rule.

Part II of the Final Report on Action 2 contains recommended changes to the OECD Model Tax Convention. It complements Part I and deals with the parts of BEPS Action 2 that indicate that the outputs of the work on that action item 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. It notes that special attention should be given to the interaction between possible changes to domestic law and the provisions of the OECD Model Tax Convention. This work would be coordinated with the work on interest expense deduction limitations, CFC rules, and treaty shopping. Furthermore, Part II specifically examines treaty issues related to dual resident entities, includes a proposal for a new treaty provision dealing with transparent entities and addresses the issue of the interaction between the recommendations included in Part I of the Final Report and the provisions of tax treaties.

The OECD released a further discussion paper entitled “ BEPS Action 2 – Branch Mismatch Structures ” on 22 August 2016. This paper takes the Hybrid Mismatch arrangements work one step further by proposing to apply similar principles to offshore branches.  The discussion paper identifies and analyses mismatches that can arise through the use of branch structures and sets out preliminary recommendations for domestic rules, based on those in the Final Report, which would neutralise the mismatches in tax outcomes arising from the use of these structures.

Australia’s response

Following a consultation initiated by the Board of Taxation on the implementation of the anti-hybrid rules, the Australian Government released a report in the 2016/17 Federal Budget, handed down on 3 May 2016, to implement the OECD hybrid mismatch rules.  It has been proposed that the rules will apply from the later of 1 January 2018 or six months after the enabling legislation receives Royal Assent.  However, such legislation has not yet been drafted.