Global Tax Alert. OECD releases final report on Hybrid Mismatch Arrangements under Action 2. Executive summary

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1 11 October 2015 Global Tax Alert EY OECD BEPS project Stay up-to-date on OECD s project on Base Erosion and Profit Shifting with EY s online site containing a comprehensive collection of resources, including news, Alerts and comment letters. Copy into your web browser: Services/Tax/OECD-baseerosion-and-profit-shiftingproject EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date OECD releases final report on Hybrid Mismatch Arrangements under Action 2 Executive summary On 5 October 2015, the Organisation for Economic Co-operation and Development (OECD) released its final report on Hybrid Mismatch Arrangements under Action 2 of its Action Plan on Base Erosion and Profit Shifting (BEPS). This report was released in a package that included final reports on all 15 BEPS Actions. The final report on Action 2, Neutralizing the Effect of Hybrid Mismatch Arrangements (the Final Report), supersedes the interim report that was released in September (the 2014 report). Similar to the 2014 report, the Final Report consists of two parts with detailed recommendations to address hybrid mismatch arrangements and reflects the consensus achieved on these issues. Part I contains recommendations on domestic law rules to address hybrid mismatch arrangements. Part II contains recommended changes to the OECD Model Tax Convention. The recommendations in Part I include specific recommendations and hybrid mismatch rules. The specific recommendations are modifications to provisions of domestic law aimed at avoiding hybrid mismatches and achieving alignment between those domestic law provisions and their intended tax policy outcomes (e.g., by not applying a dividend exemption at the level of the payee for payments that are deductible at the level of the payer). The hybrid mismatch 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

2 Payments that give rise to an indirect deduction with no inclusion arising from an imported mismatch The hybrid mismatch rules are divided into a primary response and, where applicable, a secondary or defensive rule. The defensive rule only applies where there is no hybrid mismatch rule in the counterparty jurisdiction or where the rule is not applied to the particular entity or arrangement. Each of the hybrid mismatch rules has its own specified scope of application. In a significant expansion from the 2014 report, the recommendations in Part I of the Final Report have been supplemented with further guidance and a wide array of detailed examples to explain the operation of the rules. Some outstanding issues that were identified in the 2014 report are addressed, such as the treatment of stock lending and sale and repurchase transactions, the treatment of non-interest bearing loans and the treatment of branch structures within the hybrid mismatch arrangement category for hybrid financial instruments. In addition, the Final Report includes new and detailed guidance on how to treat a payment that is included under a controlled foreign corporation (CFC) regime. Significant new guidance on the operation of the imported mismatch rule is provided as well, which includes three tracing and priority rules to determine the extent to which a payment should be treated as set-off against a deduction under an imported mismatch arrangement. Part II of the Final Report focuses on changes to be made to the OECD Model Tax Convention in addressing Action 2. It complements Part I and deals with the parts of 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. 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 Final Report recommends that every jurisdiction introduce all the rules contained in the report and that jurisdictions cooperate on measures to ensure these rules are implemented and applied consistently and effectively. EY is hosting a series of webcasts that will provide a comprehensive review of the final BEPS reports and outlook for country action. The Final Report on Action 2 will be addressed in a webcast on Financial Payments and BEPS Actions 2 and 4 on 3 December at 10am EST. Detailed discussion Part I: Recommendations for domestic law The recommended hybrid mismatch rules set out in the Final Report are designed to target particular arrangements that give rise to the following outcomes: Payments that give rise to a deduction/no inclusion outcome (D/NI outcome) (i.e., payments that are deductible under the rules of the payer jurisdiction and are not included in the ordinary income of the payee) Recommendations 1-5 deal with such D/NI outcomes Payments that give rise to a double deduction outcome (DD outcome) (i.e., payments that give rise to two deductions in respect of the same payment) Recommendations 6 and 7 deal with such DD outcomes Payments that give rise to an indirect D/NI outcome (i.e., payments that are deductible under the rules of the payer jurisdiction and that are set-off by the payee against a deduction under a hybrid mismatch arrangement) Recommendation 8 deals with such indirect D/NI outcomes 2 Global Tax Alert

3 Recommendation 1 Hybrid financial instrument rule The hybrid financial instrument rule under Recommendation 1 applies to three particular types of financing arrangements as follows: Arrangements that are treated as debt, equity or derivative contracts under local law ( financial instruments ) Arrangements involving the transfer of financial instruments where differences in the tax treatment of that arrangement result in the same financial instrument being treated as held by more than one taxpayer ( hybrid transfers ) Arrangements involving the transfer of financial instruments where a payment is made in substitution for the financing or equity return on the transferred asset and differences between the tax treatment of that payment and the underlying return on the instrument have the net effect of undermining the integrity of the hybrid financial instrument rule ( substitute payments ) With respect to a payment made under a financial instrument that results in a hybrid mismatch and a substitute payment under an arrangement to transfer a financial instrument, the hybrid financial instrument rule recommends as a primary response that the payer jurisdiction deny a deduction for such payment to the extent it gives rise to a D/NI outcome. If the payer jurisdiction does not neutralize the mismatch, then the payee jurisdiction will require such payment to be included in ordinary income to the extent the payment gives rise to a D/NI outcome. This is the defensive rule. Differences in the timing of the recognition of payments will not be treated as giving rise to a D/NI outcome for a payment made under a financial instrument, provided the taxpayer can establish to the satisfaction of a tax authority that the payment will be included as ordinary income within a reasonable period of time. Furthermore, differences in tax outcomes that are solely attributable to differences in the value ascribed to a payment (including through the application of transfer pricing) do not fall within the scope of the rule. It is stated that that the hybrid financial instrument rule only applies where the mismatch in tax treatment is attributable to the terms of the instrument (e.g., application of different accounting policies to the same instrument) rather than the status of the taxpayer or the context in which the instrument is held. For example, the hybrid financial instrument rule should not apply to a payment made to a tax-exempt recipient if this tax-exempt status is the only reason for the D/NI outcome. Furthermore, it is noted that the scope of the rule would be limited to payments made to related persons and under structured arrangements to which the taxpayer is a party. These operative terms are defined in recommendations 10 and 11 of the Final Report. In terms of exceptions to the rule, in certain circumstances the primary rule should not apply to a payment made by certain entities where the tax policy of the deduction under the laws of the payer jurisdiction is to preserve tax neutrality for the payer and payee. A number of examples are cited, including the example of a mutual fund or real estate investment trust that has the right, under domestic law, to deduct dividends in order to preserve its tax neutrality such deductible dividend payments, it is noted, generally should not give rise to a hybrid mismatch under the hybrid financial instrument rule. It is noted, however, that the defensive rule would continue to apply to any such payment on receipt. In determining the type of payments targeted under the hybrid financial instrument rule, it is important to note that the definition of payment for the purposes of the Final Report specifically excludes payments that are only deemed to be made for tax purposes. Therefore, the rule would not apply to an adjustment resulting from a deemed interest charge on equity. In addition, the Final Report includes two specific examples concerning interest-free loan arrangements, showing a difference in treatment for situations in which a borrower for tax accounting purposes accrues a deemed discount on an interest free loan and situations where a borrower claims a (deemed) deduction for tax purposes as if it had paid interest Global Tax Alert 3

4 on the loan at a market rate. The latter arrangement does not fall within the scope of the hybrid financial instrument rule, because there is no payment under the loan that gives rise to a deduction in the borrower s territory. The additional detailed analysis set out in the example notes that a deduction that arises in respect of an amount that is not capable of being paid is not considered a payment for the purposes of applying the rule. For the arrangement where a borrower splits the loan payable into two separate components for tax accounting purposes (i.e., a loan treated as having been issued at a discount and a deemed equity contribution) and there is an accrual for the deemed discount on the interest-free loan, no deduction should be available to the borrower in relation to the accrual of the deemed discount. The category of hybrid transfers is a notable addition compared to the 2014 report and is defined as being any arrangement to transfer a financial instrument where, as a consequence of the economics of the transaction and the way it is structured, the laws of two jurisdictions take opposing views on who is the owner of the underlying return on the transferred asset. The Final Report recommends that jurisdictions treat hybrid transfers as financial instruments within the scope of the hybrid financial instrument rule. Hybrid transfers include sale and re-purchase (repo) transactions and security lending transactions where the rights and obligations of the parties are structured in such a way that the transferor remains exposed to the financing or equity return on the financial instrument transferred under the arrangement. A number of detailed examples setting out the application of the hybrid financial instrument rule to such transaction types particularly with respect to traders - are included in the Final Report. Also considered in some detail under Recommendation I of the Final Report is the application of the hybrid financial instrument rule in a scenario where certain mechanisms of tax relief such as (partial) exemption, (partial) credit and rate reduction are in play. In those cases, the amount of the deduction that should be denied should generally be no more than is necessary to eliminate the mismatch in tax outcomes and a deduction should continue to be allowed to the extent the payment is subject to tax in the payee jurisdiction at the full rate. A number of examples illustrating partial exemption/credit and reduced rate scenarios are included in the Final Report. A notable area of guidance and commentary with respect to Recommendation 1 includes guidance on the treatment of payments that are included under a CFC regime. A payment that has been fully attributed to a parent (or the ultimate parent) of the group under a CFC regime and has been subject to tax at the full rate should be treated as having been included in ordinary income for the purposes of the reverse hybrid rule. In addition to the examples referenced above, a wide number of other detailed examples are also included in the Final Report. Recommendation 2 Specific recommendations for the tax treatment of financial instruments This section sets out specific recommendations for changes to the tax treatment of cross-border financial instruments in order to prevent hybrid mismatches from arising. First, it is recommended that countries do not grant a dividend exemption or equivalent tax relief for dividend payments that are treated as deductible by the payer. This recommendation only affects payments that would otherwise qualify for dividend exemption or equivalent tax relief and does not deal with other types of non-inclusion such as a payment that is treated as a return of capital. Second, in order to prevent duplication of tax credits under a hybrid transfer, the Final Report recommends limiting the ability of a taxpayer to claim relief from foreign withholding tax on instruments that are held subject to a hybrid transfer. In effect, under this recommendation, the benefit of any tax credits would be restricted in proportion to the net taxable income of the recipient taxpayer under the arrangement. Supplementary guidance and a number of detailed examples with respect to the above recommendations are also included in the Final Report. There is no limitation of scope with regard to the application of Recommendation 2. 4 Global Tax Alert

5 Recommendation 3 Disregarded hybrid payments rule Under the disregarded hybrid payments rule, a number of recommendations deal with the situation where a hybrid payer makes a deductible payment under the laws of the payer jurisdiction that is disregarded under the laws of the payee jurisdiction. Such a rule could, for example, apply to a holding company (in Country A) that lends to a direct subsidiary (in Country B), where the direct subsidiary is treated as a disregarded (transparent) entity for tax purposes in Country A but is treated as a separate (opaque) entity for tax purposes in Country B. The primary recommendation under the disregarded hybrid payments rule calls for denying a deduction for such a payment to the extent that it gives rise to a D/NI outcome. And under the recommended defensive rule, the payee jurisdiction would require such a payment to be included in ordinary income to the extent that the payment gives rise to a D/NI outcome. The Final Report goes on to note that no mismatch will arise to the extent that the deduction in the payer jurisdiction is set off against income included in ordinary income of both the payer s and payee s jurisdictions (i.e., dual inclusion income) and that any deduction that exceeds the amount of dual inclusion income may be eligible for set off against dual inclusion income in another period. The disregarded hybrid payments rule will only apply when a hybrid payer makes a disregarded payment, and the rule is limited in scope to parties within the same control group (as defined in Recommendation 11) or where the payment is made under a structured arrangement (as defined in Recommendation 10) to which the taxpayer is a party. Supplementary guidance and a number of detailed examples in relation to the disregarded hybrid payments rule also are included in the Final Report. Recommendation 4 Reverse hybrid rule The reverse hybrid rule seeks to address D/NI outcomes arising from payments made to a reverse hybrid. A reverse hybrid is any person that is treated as a separate entity by an investor and as transparent under the laws of the territory in which the person is established. With respect to a payment made to a reverse hybrid that results in a hybrid mismatch, the reverse hybrid rule recommends that the payer jurisdiction deny a deduction for such payment to the extent that it gives rise to a D/NI outcome. It is further noted that a payment will result in a hybrid mismatch if a mismatch would not have arisen had the accrued income been paid directly to the investor. In terms of scope, the reverse hybrid rule only applies where the investor, the reverse hybrid and the payer are members of the same control group (as defined in Recommendation 11) or if the payment is made under a structured arrangement (as defined in Recommendation 10) to which the payer is a party. Supplementary guidance and a number of detailed examples in relation to the reverse hybrid rule are also included in the Final Report. Recommendation 5 Specific recommendations for the tax treatment of reverse hybrids This section includes three specific recommendations in relation to the tax treatment of reverse hybrids and recommended improvements that jurisdictions could make to their domestic law in order to reduce the frequency of hybrid mismatches. As noted, the specific recommendations are not hybrid mismatch rules. First, it is recommended that jurisdictions introduce or amend their offshore investment or CFC regimes in order to prevent D/NI outcomes from arising with respect to payments to a reverse hybrid. As part of this recommendation, it is also suggested that jurisdictions consider introducing or making changes to such regimes in relation to imported mismatch arrangements. Second, it is recommended that domestic tax laws be modified to ensure that a reverse hybrid is treated as a resident taxpayer of the jurisdiction of organization if its income is not taxed in that jurisdiction and the accrued Global Tax Alert 5

6 income of the nonresident investor also is not taxed under the laws of the investor jurisdiction. This recommendation effectively encourages jurisdictions to turn off their tax transparency rules where those rules are primarily used to achieve hybrid mismatches. Third, it is recommended that jurisdictions should introduce improved tax filing and information reporting requirements in relation to tax transparent entities that are established within that jurisdiction. Such a recommendation should assist taxpayers and tax administrations in making 0a proper, more informed, determination of the payments that have been attributed to the nonresident investor that holds the reverse hybrid. Supplementary guidance and commentary in relation to the above recommendations are also included in the Final Report. Recommendation 6 Deductible hybrid payments rule The deductible hybrid payments rule under Recommendation 6 applies to a hybrid payer that makes a payment that is deductible under the laws of the payer jurisdiction and that also triggers a duplicate deduction in the parent jurisdiction. The recommended rules under the deductible hybrid payments rule are for the parent jurisdiction to deny a duplicate deduction for such payment to the extent it gives rise to a DD outcome. This is the primary response. The defensive rule, if the parent jurisdiction does not neutralize the mismatch, is for the payer jurisdiction to deny the deduction for such payment to the extent that the payment gives rise to a DD outcome. No mismatch will arise to the extent that a deduction is set-off against income that is included in income under the law of both the parent and payer jurisdictions (i.e., dual inclusion income). Furthermore, it is noted that any deduction that exceeds the amount of the dual inclusion income (i.e., the excess deduction) may be eligible for set-off against dual inclusion income in another period. In order to prevent stranded losses, the excess deduction may be allowed to the extent that the taxpayer can establish, to the satisfaction of the tax administration, that the excess deduction in the other jurisdictions cannot be set-off against income of any person under the laws of the other jurisdiction that is not dual inclusion income. A person will be treated as a hybrid payer in respect of a payment that is deductible under the laws of the payer jurisdiction where the payer is not a resident of the payer jurisdiction and the payment triggers a duplicate deduction for that payer (or a related person) under the laws of the jurisdiction where the payer is resident (the parent jurisdiction) or where the payer is resident in the payer jurisdiction and the payment triggers a duplicate deduction for an investor in that payer (or a related person) under the laws of the other jurisdiction (the parent jurisdiction). The Final Report goes on to state that the deductible hybrid payments rule only applies to a deductible payment made by a hybrid payer and such payment results in a hybrid mismatch. While there is no limitation on scope in respect of the recommended primary response, the defensive rule only applies if the parties to the mismatch are in the same control group or where the mismatch arises under a structured arrangement and the taxpayer is party to that structured arrangement. Supplementary guidance and a number of detailed examples in relation to the deductible hybrid payments rule recommendations are also included in the Final Report. Recommendation 7 Dual-resident payer rule The dual-resident payer rule under Recommendation 7 applies where the payer is a dual resident and makes a payment that is deductible under the law of both jurisdictions and that DD outcome results in a hybrid mismatch. The recommended rule under the dual-resident payer rule is for each resident jurisdiction to deny a deduction for such payment to the extent it gives rise to a DD outcome. Recommendations with respect to dual inclusion income and stranded losses are similar to those made under Recommendation 6. The rule only applies to deductible payments made by a dual resident, and that a taxpayer will be a dual resident if it is resident for tax purposes under the laws of two 6 Global Tax Alert

7 or more jurisdictions. The dualresident payer rule will only apply to payments that result in a hybrid mismatch. A hybrid mismatch will arise where a deduction for a payment may be set-off, under the laws of the other jurisdiction, against income that is not dual inclusion income. Supplementary guidance and an example in relation to the use of a consolidation regime and the use of a reverse hybrid structure involving a dual resident entity is also included in the Report. There is no limitation of scope with regard to the application of the dual-resident payer rule. Recommendation 8 Imported mismatch rule This recommendation addresses the so-called imported mismatch arrangements under which the deduction resulted from a hybrid mismatch arrangement that was produced in a different jurisdiction, is imported to a third jurisdiction and set-off the income in that third jurisdiction. The imported mismatch rule disallows deductions for a broad range of payments (including interest, royalties, rents and payments for services) if the income from such payments is setoff, directly or indirectly, against a deduction that arises under a hybrid mismatch arrangement in an offshore jurisdiction. The overriding objective of the imported mismatch rule is to maintain the integrity of the other hybrid mismatch rules by removing any incentive for multinational groups to enter into hybrid mismatch arrangements. The imported mismatch rule applies to both structured and intra-group imported mismatch arrangements and can be applied to any payment that is directly or indirectly setoff against any type of hybrid deduction. A hybrid deduction is defined as (i) a payment under a financial instrument that results in a hybrid mismatch; (ii) a disregarded payment made by a hybrid payer that results in a hybrid mismatch; (iii) a payment made to a reverse hybrid that results in a hybrid mismatch; or (iv) a payment made by a hybrid payer or dual resident that triggers a duplicate deduction resulting in a hybrid mismatch. A hybrid deduction also includes a deduction resulting from a payment made to any other person to the extent that person treats the payment as set-off against another hybrid deduction. A notable addition compared to the 2014 report in that the guidance sets out three tracing and priority rules (i.e., the structured imported mismatch rule, the direct imported mismatch rule and the indirect imported mismatch rule ) to be used by taxpayers and administrations to determine the extent to which a payment should be treated as setoff against a deduction under an imported mismatch arrangement. Further details and commentary in relation to the three tracing and priority rules above, and the mechanical steps involved in their application, are included in the Final Report. Guidance on the treatment of payments that are included under a CFC regime is also provided. As with most of the other rules in Part I of the Final Report, the scope of the imported mismatch rule is limited to taxpayers in the same control group as the parties to the imported mismatch arrangement, or to payments that are made under a structured arrangement to which the taxpayer is a party. A wide range of detailed examples in addition to supplementary commentary and guidance in relation to the imported mismatch rule also are included in the Final Report. Recommendation 9 Design principles This section calls on countries to implement and apply the rules in a coordinated manner that preserves the underlying policy objectives of the Final Report. This would ensure predictability of outcomes for taxpayers and avoid the risk of double taxation. Recommendation 9.1 addresses certain design principles reiterating that countries should seek to ensure that the domestic rules, once implemented, will apply to the same arrangements and entities, and provide for the same tax outcomes, as set out in the Final Report. The design principles state that for a rule created to address mismatches arising from the use of hybrid arrangements to be effective, it must: Operate to eliminate the mismatch without requiring the jurisdiction applying the rule to establish that it has lost tax revenue under the arrangement Global Tax Alert 7

8 Be comprehensive Apply automatically Avoid double taxation through rule co-ordination Minimize the disruption to existing domestic law Be clear and transparent in its operation Provide the flexibility necessary for the rule to be incorporated into the laws of each jurisdiction Be workable for taxpayers and keep compliance costs to a minimum Be easy for tax authorities to administer Recommendation 9.2 sets out further actions that countries should take to ensure that rules are interpreted and applied consistently on a cross-border basis. More specifically it calls for countries to: Agree on guidance on how the rules ought to be applied Develop standards that will allow co-ordination of the implementation of the recommendations, including of timing in the application of rules, minimizing impact arising from a different implementation time Identify the need for transitional rules (in this regard the recommendation states that the need for transitional arrangements can be minimized by ensuring a sufficient notice period for taxpayers and that there will be no presumption as to the need for grandfathering rules) Undertake a review of the operation of the rules as necessary to determine whether they are operating as intended Enter into exchange of information, with early and spontaneous exchange of information recognized as key to an effective implementation of hybrid mismatch rules Endeavour to make relevant information on the tax treatment of entities and financial instruments available to taxpayers Consideration of the interaction with other BEPS Actions, including providing that rules to address hybrid mismatch arrangements should be applied before application of a fixed ratio rule under Action 4 Recommendation 9 includes recommendations for domestic law design principles, implementation and coordination that are similar to those in the 2014 report Recommendation 10 Definition of structured arrangement Recommendation 10 includes a general definition of a structured arrangement as well as a list of specific examples of structured arrangements. A structured arrangement is any arrangement where the hybrid mismatch is priced into the terms of the arrangement or the facts and circumstances (including the terms) of the arrangement indicate that it has been designed to produce a hybrid mismatch. The hybrid mismatch rules apply to any person who is a party to a structured arrangement. The purpose of the structured arrangement definition is to capture those taxpayers who enter into arrangements that have been designed to produce a mismatch in tax outcomes while ensuring taxpayers will not be required to make adjustments in circumstances where the taxpayer is unaware of the mismatch and derives no benefit from it. Recommendation 10.3 therefore excludes a taxpayer from the structured arrangement rule where the taxpayer is not a party to the structured arrangement. The definition of structured arrangement in the Final Report does not significantly deviate from the 2014 report, but the Final Report contains significantly more explanation regarding the definition. Recommendation 11 Definitions of related persons, control group and acting together With respect to hybrid financial instruments and hybrid transfers, the scope of the hybrid mismatch rules covers such transactions between related parties. Other hybrid mismatch arrangements are generally treated as within scope of the recommendations where the parties to the mismatch are members of the same control group. Two persons will be treated as related if they form part of the same control group or if one person 8 Global Tax Alert

9 has a 25% investment in the other person or a third person has a 25% investment in both. Persons who are acting together in respect of the ownership or control of an investment in certain circumstances are required to aggregate their ownership interests for the purposes of the related party test. In addition, two persons would be in the same control group if (i) they are consolidated for accounting purposes; (ii) the first person has an investment in a second person that grants the former effective control, or a third person has such an investment in the first two; (iii) the first person has a 50% or greater investment in the second person, or a third person has a 50% or greater investment in both; or (iv) the two persons can be regarded as associated enterprises under Article 9 of the OECD Model Tax Convention. A person will be regarded as holding an investment if it directly or indirectly holds a percentage of voting rights or value in equity of another person. The definitions in the Final Report do not significantly deviate from the 2014 report, but the Final Report contains significantly more explanation regarding the definitions. Recommendation 12 Other definitions The Final Report notes that the language of the recommendations is not meant to be translated directly into domestic legislation. Countries are expected to implement these recommendations into domestic law using their own concepts and terminology. At the same time, the rules in one country need to be coordinated with the rules in other countries. Recommendation 12 therefore includes a wide array of definitions for purposes of the recommendations included in the Final Report, with the aim of ensuring consistency in the application of the rules. Part II Recommendations on treaty issues Part II of the Final Report contains recommendations on changes to the OECD Model Tax Convention to be made to ensure that hybrid instruments and entities are not used to obtain treaty benefits inappropriately and to address treaty issues that may arise from the recommended domestic law changes. Chapter 13 Dual resident entities The first recommendation made is with respect to dual-resident entities. The Final Report makes a reference to new proposed Article 4(3) to the OECD Model Tax Convention as part of the work on Action 6 on treaty abuse. The proposed article states that the residence of a dual-resident entity should be determined mutually by the competent authorities of the relevant jurisdictions and that in the absence of an agreement, the dual-resident entity cannot claim treaty benefits from any of the jurisdictions involved. However, the Final Report states that treaty changes alone would not effectively mitigate BEPS concerns associated with dual-resident entities. Such changes will not, for instance, address avoidance strategies resulting from an entity being a resident of a country under that country s domestic law while, at the same time, being a resident of another country under a tax treaty concluded by the first country. This situation may allow an entity to benefit from the advantages applicable to residents under domestic law without being subject to reciprocal obligations (e.g., being able to shift its foreign losses to another resident company under a domestic law group relief system while claiming treaty protection against taxation of its foreign profits). For these situations, the Final Report suggests changes to domestic law that would deny residency of an entity under domestic law if the entity is treated as resident in another jurisdiction under the applicable income tax treaty. The Final Report does not reflect significant changes in comparison to the 2014 report. Chapter 14 Transparent entities The second recommendation addresses the use of transparent entities to benefit from treaty provisions inappropriately. In this respect, the Final Report recommends an amendment to Article 1(2) of the OECD Model Tax Convention to include a rule on fiscally transparent entities whereby income derived by or through an entity or arrangement that is treated as wholly or partly Global Tax Alert 9

10 fiscally transparent under the tax law of one of the countries will be considered to be income of a resident only to the extent that the income is treated, for purposes of taxation by that country, as the income of a resident of that country. Such change would include additions to the Commentary. The Commentary refers to the principles reflected in the 1999 report of the Committee of Fiscal Affairs that focused on the application of the OECD Model Tax Convention to partnerships (the Partnership Report). The proposed new Commentary expands the principles in the Partnership Report to other non-corporate entities. The Final Report does not reflect significant changes in comparison to the 2014 report. Chapter 15 Interaction between Part I and tax treaties Part II next comments on the necessity of coordinating with the rules recommended under Part I of the Final Report and how the suggested domestic law changes may affect specific articles of the OECD Model Tax Convention. With respect to the rule providing for the denial of deductions, the Final Report notes that treaties do not govern whether a payment is deductible. Such decision is left to the domestic laws and therefore the recommended rule would not infringe any treaty provision. Furthermore, with respect to the defensive rules that require an inclusion of a payment as ordinary income, the Final Report indicates that such a rule would directly affect the provisions in the OECD Model Tax Convention if such rule sought the imposition of tax on a nonresident whose income would not, under the provisions of any treaty, be taxable in such a country. However, for all the rules recommended in this Final Report, the term taxpayer contemplates the imposition of tax by a jurisdiction only when the recipient is resident of such jurisdiction or has a permanent establishment in it. Consequently, any interaction between the recommendations and the provisions of tax treaties will relate primarily to the rules concerning the elimination of double taxation. In this respect, Article 23 A (Exemption Method), as it is worded in the OECD Model Tax Convention would not create problems for jurisdictions that adopt the recommendations made in Part I of the Final Report, because it specifies that the credit method of Article 23 B (Credit Method) of the OECD Model Tax Convention typically applies to dividends. However, the Final Report notes that a number of bilateral tax treaties depart from this approach and apply the exemption method with respect to dividends and provides general comments on how to resolve this problem. The most complete solution suggested is for these countries to consider including rules in their treaties that would allow them to apply the credit method as opposed to the exemption method. Likewise, Article 23 B is regarded as consistent with the recommendations in Part I of the Final Report. The only issue noted relates to situations where the parties to a tax treaty either supplement or depart from the basic credit approach of OECD Model Tax Convention Article 23 B. Finally, the Final Report analyzes the potential application of the anti-discrimination provisions of the OECD Model Tax Convention and concludes that subject to an analysis of the precise wording of the domestic rules that would be drafted to implement the recommendations, the recommendations set out in Part I of the Final Report would not appear to raise concerns about a possible conflict with the provisions of Article 24. Implications Following the discussion drafts released in March 2014, 2 extensive comments from stakeholders on those discussion drafts and the 2014 report, this Final Report is the conclusive output on Action 2. The recommendations included in the Final Report incorporate some of the input the OECD received from stakeholders and reflects the consensus reached on those issues. At this stage, implementation via changes in domestic law and practices and via treaty provisions is at the discretion of individual countries. The Final Report is an expansive document and it contains very complex recommendations. Considering this complexity 10 Global Tax Alert

11 and the difficulties countries may face in incorporating these recommendations into their domestic tax system, it remains to be seen to what extent countries will adopt these rules. However, countries have already begun adopting anti-hybrid measures of various types in advance of the final output on Action 2 from the OECD. In general, OECD countries have agreed to continue to work together to ensure a consistent and coordinated implementation of the BEPS recommendations across all of the Actions. To further this objective, by early 2016 the OECD and G20 will develop an inclusive framework for monitoring, with all interested countries participating on an equal basis. Progress on the implementation of Action 2 should be subject to monitoring and further discussions are likely to be needed in order to ensure implementation by countries in a consistent manner. Webcasts EY is hosting a series of eight tax webcasts that will provide a comprehensive review of the final BEPS reports and the outlook for country action: OECD BEPS Project Outcomes: Highlights and Next Steps 15 October, 10am EDT New Reporting under BEPS Action October, 10am EDT Digital Economy Developments and BEPS Action 1 27 October, 12 noon EDT Permanent Establishment Developments and BEPS Action 7 5 November, 10am EST Transfer Pricing and BEPS Actions November, 10am EST Anti-abuse Measures under BEPS Actions 3, 5, 6 and November, 10am EST Financial Payments and BEPS Actions 2 and 4 3 December, 10am EST Dispute Resolution and BEPS Action December, 10am EST For more information and to register for the webcast series, click here. Endnotes 1. See EY Global Tax Alert, OECD releases report under BEPS Action 2 on hybrid mismatch arrangements, dated 24 September BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements (Recommendations for Domestic Laws) and BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements (Treaty Issues), both dated 19 March Global Tax Alert 11

12 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (India), National Tax Leader, Mumbai Sudhir Kapadia Ernst & Young LLP (India), International Tax Services Leader, Hyderabad Jayesh Sanghvi Ernst & Young LLP (India), Transfer Pricing Leader, New Delhi Vijay Iyer Ernst & Young LLP, Global Tax Desk Network, New York Gerrit Groen Jurjan Wouda Kuipers Dirk Jan Sloof Job Grondhout Karl Doyle Ernst & Young LLP, International Tax Services, Washington, DC Barbara Angus Global Tax Alert

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