WORKING PAPER. Brussels, 16 November 2016 WK 877/2016 INIT LIMITE FISC

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1 Brussels, 16 November 2016 WK 877/2016 INIT LIMITE FISC WORKING PAPER This is a paper intended for a specific community of recipients. Handling and further distribution are under the sole responsibility of community members. MEETING DOCUMENT From: To: Subject: Presidency Delegations Proposal for a Council Directive amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries - Presidency slides Delegations will find attached the Presidency slides that were presented during the Working Party on Tax Questions (Direct Taxation - ATAD) on 15 November WK 877/2016 INIT LIMITE EN

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3 Presentation of Slovak Presidency In this presentation we: 1) provide high-level overview of the basic structure of the Commission proposal 2) indicate how the revised draft set out in the room document incorporates key MS comments 3) discuss some of the challenges we have had in incorporating MS comments into the Commission draft 4) consider potential modifications that could be made to the Commission proposal in: defining hybrid mismatches; and providing for primary and secondary rules in relation to each of those mismatches that would simplify the drafting and bring ATAD 2 closer the approach set out in Action 2.

4 Structure of Commission Draft

5 Basic structure of Commission Proposal Scope test is built into the definition of hybrid mismatch Single definition of hybrid mismatch covering all instruments and entities Definition does not identify which types of arrangements give rise to which type of outcomes Dual inclusion income qualifies all types of mismatches but only to extent they produce DD outcomes Hybrid transfer introduced as a separate concept (rather than incorporated into definition of hybrid financial instrument)

6 Basic structure of Commission Proposal Draft assumes that an arrangement that gives rise to mismatch between MS will not involve third countries Draft does not articulate an explicit ordering rule for DD mismatches involving third countries By making an adjustment only in the jurisdiction where the payment has its source (rather then the payer jurisdiction) final outcome is less comprehensive than Action 2 Recommendations Secondary rule applies in respect of all D/NI mismatches (rather than just financial instrument and hybrid payer mismatches) as per Action 2 Report

7 Incorporating comments from MS into Commission Proposal

8 Incorporating MS comments into Commission Proposal Redraft amends the scope to include branches and exclude mismatches in parent jurisdiction for DD structures (by adjusting structured arrangement defn) Redraft expands the definition of hybrid mismatch to cover all the arrangements covered by Action 2 Redraft clarifies the payer and payee jurisdiction in context of D/NI mismatches Redraft defines when a payment is included and covers timing mismatches for financial instruments Redraft clarifies definition of dual inclusion income so that it only applies in those cases where it is relevant Redraft incorporates hybrid transfer into financial instrument definition Redraft includes new definition of hybrid entity to cope with expanded definition of hybrid mismatch

9 Incorporating MS comments into Commission Proposal Re-draft restricts the scope of first paragraph so that it does not apply where a third country is involved Primary rule for third countries is aligned with primary rule for member states (to avoid potential for conflict) Clear rule ordering for secondary rule Redraft uses concept of payer and payee jurisdiction for D/NI outcomes to ensure alignment with Action 2 Primary rule for third countries is aligned with primary rule for member states Limit the secondary rule to D/NI mismatches to exclude payments to reverse hybrid and PE (as per Action 2 Report)

10 Incorporating comments from MS into commission proposal While the re-draft incorporates the substance of MS comments, the final product is longer, more complex and repetitive and confusing (and still leaves the potential for gaps and inconsistencies with Action 2 Recommendations). By bringing the language and structure of the Commission closer to that of the Action 2 Report it is possible, however, to produce a draft that is shorter, less complex, avoids repetition and that avoids creating gaps and inconsistencies with Action 2.

11 What have been the main challenges in incorporating MS comments into the framework of the Commission Proposal?

12 Single definition of hybrid mismatch Challenges A single definition covering all hybrid mismatches in Action 2 report results in complicated drafting that could undermine the clarity and certainty of ATAD 2. Amended definition does not have the same precision as the Action 2 Report in describing when each mismatch should be treated as hybrid A single scoping rule for all types mismatches (rather than by reference to each mismatch) could create both gaps and implementation issues. Solution A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. A separate scoping rule that defines the scope of the hybrid mismatch rules with respect to each type of mismatch.

13 Definitions of payer / payee Challenge: Different definitions of payer and payee jurisdiction are needed depending on nature of the mismatch. These definitions need to be comprehensive and avoid creating co-ordination issues with non-eu countries. Solution: Use defined terms that are in-line with those used in the Action 2 Report. This would: Make the directive easier to understand: Ensure consistency of outcomes and eliminate current gaps in drafting

14 Some concepts are only relevant to certain types of mismatches Challenge: Some concepts (such as dual inclusion income) are only relevant to certain types of mismatches. Because Commission proposal uses a single definition hybrid mismatch it then becomes necessary to qualify the application of these concepts within the definition itself. Solution: If the hybrid mismatch definition follows the categories set out in the Action 2 Report - then this we could leverage this basic structure to more clearly and accurately define the scope of each concept.

15 Different rules for inside and outside Europe Challenge Current draft of ATAD has different rules for EU and non- EU mismatches. This creates unnecessary duplication as well as the risk of gaps, inconsistencies and co-ordination issues. Solution Set out single set of rules for neutralising all DD and D/NI mismatches MS could still agree to apply only the primary rule in the case of mismatches that arose wholly within the EU (if this was considered necessary or desirable)

16 Secondary rule does not apply to all hybrid mismatches Challenge Action 2 report does not apply the secondary rule to reverse hybrid and certain branch mismatches Current draft (see language) is cumbersome and confusing Solution Set out single set of hybrid mismatch rules for neutralising all types of mismatches Dis-apply the secondary rule where the D/NI mismatch is the result of payment to a reverse hybrid or branch (crossreferencing the relevant category of mismatch in the hybrid mismatch definition).

17 Proposals for Modifying the Commission Draft

18 Summary of challenges Definition of hybrid mismatch: is now more comprehensive but MS additions have also made the drafting more cumbersome and complex; still lacks the accuracy of definitions in the Action 2 Report. Risks of gaps and inconsistencies remain (due to differences in approach and terminology between Action 2 report and Commission proposal) Different rules for inside and outside EU complicate the Commission proposal when compared to Action 2

19 Suggested drafting solutions A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. A separate scoping rule that defines the scope of the hybrid mismatch rules with respect to each type of mismatch Defined terms that are in-line with those used in the Action 2 Report in order to make the directive easier to understand and to ensure consistency of outcomes and eliminate current gaps in drafting Single set of rules for neutralising all DD and D/NI mismatches - but MS could agree to apply only the primary rule in the case of mismatches that arose wholly within the EU (if this was considered necessary or desirable) where the D/NI mismatch is the result of payment to a reverse hybrid or branch (consistent with Action 2 Report)

20 Definition of hybrid mismatch A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. (a) Payments under a hybrid financial Instrument giving rise to D/NI outcome Recommendation 1 (b) Payments to a hybrid entity or permanent establishment giving rise to D/NI outcome Recommendation 4 (c) Payments by a hybrid entity (or deemed payments between branch and head office) giving rise to a D/NI outcome Recommendation 3 (d) DD outcomes Recommendation 6 & 7 Application of primary and secondary rules and other elements such as dual inclusion income depends on underlying nature of the mismatch

21 Definition of hybrid mismatch A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. (a) Payments under a hybrid financial Instrument giving rise to D/NI outcome Recommendation 1 (b) Payments to a hybrid entity or permanent establishment giving rise to D/NI outcome Recommendation 4 Financial instruments include timing mismatches and both the primary and secondary rules apply (c) Payments by a hybrid entity (or deemed payments between branch and head office) giving rise to a D/NI outcome Recommendation 3 (d) DD outcomes Recommendation 6 & 7 Application of primary and secondary rules and other elements such as dual inclusion income depends on underlying nature of the mismatch

22 Definition of hybrid mismatch A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. (a) Payments under a hybrid financial Instrument giving rise to D/NI outcome Recommendation 1 (b) Payments to a hybrid entity or permanent establishment giving rise to D/NI outcome Recommendation 4 (c) Payments by a hybrid entity (or deemed payments between branch and head office) giving rise to a D/NI outcome Recommendation 3 (d) DD outcomes Recommendation 6 & 7 Timing differences are not relevant for hybrid and branch payee mismatches and there is no requirement to apply the secondary rule under Action 2 Application of primary and secondary rules and other elements such as dual inclusion income depends on underlying nature of the mismatch

23 Definition of hybrid mismatch A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action Both primary 2 Report. and secondary rules apply to hybrid payer mismatches that give rise to D/NI (a) Payments outcomes under but adjustment a hybrid is financial limited to Instrument the extent giving rise to D/NI outcome Recommendation set-off against 1dual inclusion income (b) Payments to a hybrid entity or permanent establishment giving rise to D/NI outcome Recommendation 4 (c) Payments by a hybrid entity (or deemed payments between branch and head office) giving rise to a D/NI outcome Recommendation 3 (d) DD outcomes Recommendation 6 & 7 Application of primary and secondary rules and other elements such as dual inclusion income depends on underlying nature of the mismatch

24 Definition of hybrid mismatch A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. (a) Payments under a hybrid financial Instrument giving rise to D/NI outcome Recommendation 1 (b) Payments to a hybrid entity or permanent establishment giving rise to D/NI outcome DD outcomes can arise through hybrid Recommendation 4 entity or branch. Both primary and (c) Payments by a hybrid entity (or deemed secondary payments rules could between apply branch but adjustment and head office) giving rise to a D/NI outcomeis limited by the amount of dual inclusion Recommendation 3 income in the structure. (d) DD outcomes Recommendation 6 & 7 Application of primary and secondary rules and other elements such as dual inclusion income depends on underlying nature of the mismatch

25 Definitions in line with Action 2 'hybrid mismatch means: (a) (b) (c) (d) a payment under a financial instrument that gives rise to a deduction without inclusion outcome where: (i) such payment cannot reasonably be expected to be included in income within a reasonable period of time; and (ii) the mismatch is attributable to the differences in the characterisation of the instrument or the payment made under it. a payment to a hybrid entity or permanent establishment that gives rise to a deduction without inclusion where the mismatch is a result of differences in the recognition of payments made to the permanent establishment or hybrid entity; a payment by a hybrid entity or a deemed payment between two parts of the same entity that gives rise to a deduction without inclusion where the mismatch is a result of the fact that the payment is disregarded under the laws of the payee jurisdiction; a double deduction outcome; provided that a hybrid mismatch only arises under paragraph (c) or (d) above to the extent the deduction is set off against income that is not dual-inclusion income.

26 Definitions in line with Action 2 'hybrid mismatch means: (a) (b) (c) (d) Note this structure allows for a more accurate definition of the circumstances when a mismatch should be considered hybrid a payment under a financial instrument that gives rise to a deduction without inclusion outcome where: (i) such payment cannot reasonably be expected to be included in income within a reasonable period of time; and (ii) the mismatch is attributable to the differences in the characterisation of the instrument or the payment made under it. a payment to a hybrid entity or permanent establishment that gives rise to a deduction without inclusion where the mismatch is attributable to differences in the recognition of payments made to the permanent establishment or hybrid entity; a payment by a hybrid entity or a deemed payment between two parts of the same entity that gives rise to a deduction without inclusion where the mismatch is a result of the fact that the payment is disregarded under the laws of the payee jurisdiction; a double deduction outcome; provided that a hybrid mismatch only arises under paragraph (c) or (d) above to the extent the deduction is set off against income that is not dual-inclusion income.

27 Definitions in line with Action 2 'hybrid mismatch means: (a) a payment under a financial instrument that gives rise to a deduction without Note that inclusion this approach outcome also where: makes it much easier (i) to apply such concepts payment such cannot as reasonably be expected to be included in dual inclusion income income within a reasonable period of time; and (ii) the mismatch is attributable to the differences in the characterisation of the instrument or the payment made under it. (b) a payment to a hybrid entity or permanent establishment that gives rise to a deduction without inclusion where the mismatch is a result of differences in the recognition of payments made to the permanent establishment or hybrid entity; (c) a payment by a hybrid entity or a deemed payment between two parts of the same entity that gives rise to a deduction without inclusion where the mismatch is a result of the fact that the payment is disregarded under the laws of the payee jurisdiction; (d) a double deduction outcome; provided that a hybrid mismatch only arises under paragraph (c) or (d) above to the extent the deduction is set off against income that is not dual-inclusion income.

28 Definitions in line with Action 2 mismatch means a double deduction or a deduction without inclusion. double deduction means a deduction of the same payment, expenses or losses in the jurisdiction in which the payment has its source, the expenses are incurred or the losses are suffered (source jurisdiction) and in another jurisdiction (parent jurisdiction); deduction without inclusion means the deduction of a payment in any jurisdiction where the payment is treated as made (payer jurisdiction) without a corresponding inclusion for tax purposes of the same payment in any jurisdiction where the payment is treated as being received (payee jurisdiction). A payment will be treated as included to the extent a taxpayer brings that payment into account in calculating its taxable income. A payment should not be treated as included, however, to the extent the payee jurisdiction generally allows for payments of that character to benefit from an exemption from tax, a reduction in the rate of tax or any credit or refund of tax (other than a credit for taxes withheld at source). dual inclusion income is any item of income that is included under the laws of the two jurisdictions where the mismatch has arisen.

29 Definitions in line with Action 2 Note definitions of source, parent, payer and payee jurisdictions that are mismatch means a double deduction or a deduction without consistent inclusion. with Action 2 Report double deduction means a deduction of the same payment, expenses or losses in the jurisdiction in which the payment has its source, the expenses are incurred or the losses are suffered (source jurisdiction) and in another jurisdiction (parent jurisdiction); deduction without inclusion means the deduction of a payment in any jurisdiction where the payment is treated as made (payer jurisdiction) without a corresponding inclusion for tax purposes of the same payment in any jurisdiction where the payment is treated as being received (payee jurisdiction). A payment will be treated as included to the extent a taxpayer brings that payment into account in calculating its taxable income. A payment should not be treated as included, however, to the extent the payee jurisdiction generally allows for payments of that character to benefit from an exemption from tax, a reduction in the rate of tax or any credit or refund of tax (other than a credit for taxes withheld at source). dual inclusion income is any item of income that is included under the laws of the two jurisdictions where the mismatch has arisen.

30 Definitions in line with Action 2 mismatch means a double deduction or a deduction without inclusion. double deduction means a deduction of the same payment, expenses or losses in the jurisdiction in which the payment has its source, the expenses are incurred or the losses are suffered (source jurisdiction) and in another jurisdiction Further definition (parent of jurisdiction); when a payment should be treated as included for tax deduction without inclusion means the deduction of a payment purposes in any jurisdiction where the payment is treated as made (payer jurisdiction) without a corresponding inclusion for tax purposes of the same payment in any jurisdiction where the payment is treated as being received (payee jurisdiction). A payment will be treated as included to the extent a taxpayer brings that payment into account in calculating its taxable income. A payment should not be treated as included, however, to the extent the payee jurisdiction generally allows for payments of that character to benefit from an exemption from tax, a reduction in the rate of tax or any credit or refund of tax (other than a credit for taxes withheld at source). dual inclusion income is any amount that is included under the laws of the two jurisdictions where the mismatch has arisen.

31 Definitions in line with Action 2 mismatch means a double deduction or a deduction without inclusion. double deduction means a deduction of the same payment, expenses or losses in the jurisdiction in which the payment has its source, the expenses are incurred or the losses are suffered (source jurisdiction) and in another jurisdiction (parent jurisdiction); Definition of mismatch ensures that deduction without inclusion means the deduction of Definition a payment of in mismatch any jurisdiction ensures where that dual inclusion income operates both the payment is treated as made (payer jurisdiction) without dual inclusion a corresponding income is inclusion effective for in in context of in D/NI and DD tax purposes of the same payment in any jurisdiction where both the D/NI payment and DD is outcomes treated as outcomes being received (payee jurisdiction). A payment will be treated as included to the extent a taxpayer brings that payment into account in calculating its taxable income. A payment should not be treated as included, however, to the extent the payee jurisdiction generally allows for payments of that character to benefit from an exemption from tax, a reduction in the rate of tax or any credit or refund of tax (other than a credit for taxes withheld at source). dual inclusion income is any amount that is included under the laws of the two jurisdictions where the mismatch has arisen.

32 Application of primary and secondary rules 1. To the extent that a hybrid mismatch results in a double deduction: (a) the deduction shall be denied in the parent jurisdiction; and (b) if the deduction is not denied in the parent jurisdiction, the deduction shall be denied in the source jurisdiction 2. To the extent that a hybrid mismatch results in a deduction without inclusion: (a) the deduction shall be denied in the payer jurisdiction; and (b) if the deduction is not denied in the payer jurisdiction, the amount of the payment that would otherwise give rise to a mismatch shall be included in the payee jurisdiction. 3. Carve outs (a) A Member State shall not be obliged to apply Article 9(2)(b) to hybrid mismatch as defined in Article 2(9)(b). (b) A Member State not be obliged to apply Article 9(1)(b) or 9(2)(B) to hybrid mismatch that arises wholly within the Union (c) Paragraph 1(b) and paragraph 2 shall not apply unless the mismatch arises in respect of a deemed payment, structured arrangement or an arrangement between associated enterprises.

33 Application of primary and secondary rules Full set of primary and secondary rules for both types of mismatches 1. To the extent that a hybrid mismatch results in a double deduction: (a) the deduction shall be denied in the parent jurisdiction; and (b) if the deduction is not denied in the parent jurisdiction, the deduction shall be denied in the source jurisdiction 2. To the extent that a hybrid mismatch results in a deduction without inclusion: (a) the deduction shall be denied in the payer jurisdiction; and (b) if the deduction is not denied in the payer jurisdiction, the amount of the payment that would otherwise give rise to a mismatch shall be included in the payee jurisdiction. 3. Carve outs (a) A Member State shall not be obliged to apply Article 9(2)(b) to hybrid mismatch as defined in Article 2(9)(b). (b) A Member State not be obliged to apply Article 9(1)(b) or 9(2)(B) to hybrid mismatch that arises wholly within the Union (c) Paragraph 1(b) and paragraph 2 shall not apply unless the mismatch arises in respect of a payment or deemed payment by a permanent establishment, or under a structured arrangement or an arrangement between associated enterprises.

34 Application of primary and secondary rules 1. To the extent that a hybrid mismatch results in a double deduction: (a) the deduction shall be denied in the parent jurisdiction; and (b) if the deduction is not denied in the parent jurisdiction, the deduction shall be denied in the source jurisdiction No secondary rule in respect of hybrid 2. To the extent that a hybrid mismatch results in a deduction payer without mismatches inclusion: (a) the deduction shall be denied in the payer jurisdiction; and (b) if the deduction is not denied in the payer jurisdiction, the amount of the payment that would otherwise give rise to a mismatch shall be included in the payee jurisdiction. 3. Carve outs (a) A Member State shall not be obliged to apply Article 9(2)(b) to hybrid mismatch as defined in Article 2(9)(b). (b) A Member State not be obliged to apply Article 9(1)(b) or 9(2)(B) to hybrid mismatch that arises wholly within the Union (c) Paragraph 1(b) and paragraph 2 shall not apply unless the mismatch arises in respect of a payment or deemed payment by a permanent establishment, or under a structured arrangement or an arrangement between associated enterprises.

35 Application of primary and secondary rules 1. To the extent that a hybrid mismatch results in a double deduction: (a) the deduction shall be denied in the parent jurisdiction; and (b) if the deduction is not denied in the parent jurisdiction, the deduction shall be denied in the source jurisdiction 2. To the extent that a hybrid mismatch results in a deduction without inclusion: (a) the deduction shall be denied in the payer jurisdiction; and (b) if the deduction is not denied in the payer jurisdiction, the amount of the payment that would No otherwise requirement give to rise apply to a secondary mismatch rule shall to be included in the payee jurisdiction. intra-eu mismatches (if that is what MS agree) 3. Carve outs (a) A Member State shall not be obliged to apply Article 9(2)(b) to hybrid mismatch as defined in Article 2(9)(b). (b) A Member State not be obliged to apply Article 9(1)(b) or 9(2)(B) to hybrid mismatch that arises wholly within the Union (c) Paragraph 1(b) and paragraph 2 shall not apply unless the mismatch arises in respect of a payment or deemed payment by a permanent establishment, or under a structured arrangement or an arrangement between associated enterprises.

36 Application of primary and secondary rules 1. To the extent that a hybrid mismatch results in a double deduction: (a) the deduction shall be denied in the parent jurisdiction; and (b) if the deduction is not denied in the parent jurisdiction, the deduction shall be denied in the source jurisdiction 2. To the extent that a hybrid mismatch results in a deduction without inclusion: (a) the deduction shall be denied in the payer jurisdiction; and (b) if the deduction is not denied in the payer jurisdiction, the amount of the payment that would otherwise give rise to a mismatch shall be included in the payee jurisdiction. 3. Carve outs Scoping rule (a) A Member State shall not be obliged to apply Article 9(2)(b) to hybrid mismatch as defined in Article 2(9)(b). (b) A Member State not be obliged to apply Article 9(1)(b) or 9(2)(B) to hybrid mismatch that arises wholly within the Union (c) Paragraph 1(b) and paragraph 2 shall not apply unless the mismatch arises in respect of a payment or deemed payment by a permanent establishment, or under a structured arrangement or an arrangement between associated enterprises.

37 Suggested drafting solutions A definition of hybrid mismatch that more accurately identifies each type of mismatch by reference to the categories set out in the Action 2 Report. A separate scoping rule that defines the scope of the hybrid mismatch rules with respect to each type of mismatch Defined terms that are in-line with those used in the Action 2 Report in order to make the directive easier to understand and to ensure consistency of outcomes and eliminate current gaps in drafting Single set of rules for neutralising all DD and D/NI mismatches - but MS could agree to apply only the primary rule in the case of mismatches that arose wholly within the EU (if this was considered necessary or desirable) where the D/NI mismatch is the result of payment to a reverse hybrid or branch (consistent with Action 2 Report)

38 Thank you for your attention