Global Tax Alert. OECD releases report under BEPS Action 2 on hybrid mismatch arrangements. Executive summary

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1 23 September 2014 EY 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 report under BEPS Action 2 on hybrid mismatch arrangements Executive summary On 16 September 2014, the Organisation for Economic Co-operation and Development (OECD) released a series of deliverables that address seven of the focus areas in its Action Plan on Base Erosion and Profit Shifting (BEPS). The report under Action 2, titled Neutralising the Effects of Hybrid Mismatch Arrangements (the Hybrid Mismatch Report or Report) consists of two parts providing recommendations with respect to domestic law provisions and treaty provisions. The first part of the Hybrid Mismatch Report makes recommendations for domestic rules to address mismatches generally consisting of multiple deductions for a single expense, deductions in one country without corresponding income inclusion in another country or the generation of multiple foreign tax credits for one amount of foreign tax paid. The Report recommends the enactment of linking rules that seek to relate the tax treatment of a payment with respect to a specific hybrid entity or arrangement in one jurisdiction to the tax treatment of such payment granted in the counterparty jurisdiction. Further, it suggests a rule order under which primary and defensive rules would operate to address the unwanted double non-taxation (i.e., double deduction or direct or indirect deduction and non-inclusion) outcomes and avoid double taxation. Lastly, reflecting the comments received from the business community and stakeholders, the Hybrid Mismatch Report limits the scope of the recommended rules by using the bottom up approach. More specifically, the recommended rules would apply to hybrid arrangements involving related parties (the threshold for which has been increased to 25%) and members of the same controlled group and to certain structured arrangements. The second part of the Hybrid Mismatch Report describes changes to the OECD Model Tax Convention to ensure that hybrid instruments and entities do not unduly benefit from treaty provisions and to coordinate between the domestic law recommendations and tax treaty provisions. In particular, the report includes (i) a discussion of the proposed new Article 4(3) of the Model Tax Convention as put

2 forward in the report on treaty abuse under Action 6 in the context of dual resident entities; (ii) a new provision in Article 1 and changes to the associated Commentary to address fiscally transparent entities; and (iii) various proposed changes to address treaty issues that may arise from the recommended domestic law changes. The Report indicates that the OECD is continuing its work on Action 2 to address certain substantive and implementation issues. The OECD intends to develop guidance on how the rules would operate in practice. The Report also notes that there are specific areas where the recommended domestic law rules may need further refinement. The two areas specified are the treatment of certain capital market transactions such as on-market stock-lending and repos and the rules on imported hybrid mismatches (i.e., deduction/ non-inclusion outcome extended to a third jurisdiction by using intercompany loans). In addition, the OECD will further explore concerns raised by countries and business with respect to the application of the rules to intragroup hybrid regulatory capital. The OECD also will address the potential treatment of inclusions under controlled foreign company (CFC) rules as included in income for purposes of the Report. It is anticipated that this work will be finalized in September of Detailed discussion Background Action 2 of the BEPS Action Plan, released on 19 July 2013, generally regarded hybrid mismatch arrangements as tools that can potentially achieve unintended double non-taxation or long-term tax deferral. The Report states that interest in neutralizing mismatches of tax treatment from hybrid arrangements has long been a concern of tax administrators, as reflected in a 2012 OECD report titled, Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues (the 2012 report). The 2012 report asserts that rules allowing taxpayers to choose the tax treatment of certain entities and a dichotomy in the tax treatment of a payment between domestic and foreign tax laws could facilitate hybrid mismatches. On 19 March 2014, the OECD released two discussion drafts (Discussion Drafts) on Action 2, the first of which containing recommendations for the design of domestic rules aimed at the neutralization of hybrid mismatch arrangements and the second of which providing recommendations on amendments to the OECD Model Tax Convention (see EY Global TaxAlert, OECD releases discussion drafts on neutralizing hybrid mismatch arrangements under BEPS Action 2, dated 7 April 2014, for more information on the Discussion Drafts). The Hybrid Mismatch Report generally follows the discussion and recommendations included in the Discussion Drafts, with some significant refinements. Most notably, the Hybrid Mismatch Report limits the scope of the recommended rules by using the so-called bottom up approach. As a result, most of the recommended rules would apply only to hybrid arrangements involving related parties (the threshold for which has been increased to 25%) and members of the same controlled group and to certain structured arrangements. Part I: Recommendations for domestic laws Design principles, implementation and coordination The Hybrid Mismatch Report includes most of the design principles and the implementation and coordination measures included in the Discussion Drafts with some reformulations. In this regard, the Report states that the hybrid mismatch rules are designed to: Neutralize the mismatch in tax treatments (they are not intended to change the tax characterization and commercial outcome of the arrangement or instrument) Be comprehensive Apply automatically Avoid double taxation through rule coordination Minimize the disruption to existing domestic law Be clear and transparent in their operation Provide sufficient flexibility to allow for implementation in each jurisdiction Be workable for taxpayers and keep compliance costs to a minimum Be easy for tax authorities to administer 2

3 The Report states that jurisdictions should cooperate on measures to ensure recommendations are implemented and applied consistently and effectively. These measures include: Development of agreed guidance on the recommendations Coordination of the implementation of the recommendations (including timing) Development of transitional rules (without any presumption as to grandfathering of existing arrangements) Review of the effective and consistent implementation of the recommendations Exchange of information on the jurisdiction treatment of hybrid financial instruments and hybrid entities Endeavoring to make relevant information available to taxpayers (including reasonable endeavors by the OECD) Consideration of the interaction of the recommendations with other Actions under the BEPS Action Plan, including Actions 3 and 4 Definitions As in the Discussion Drafts, the Report defines hybrid mismatches generally as arrangements that incorporate techniques that exploit a difference in the characterization of an entity or arrangement under the laws of two or more tax jurisdictions to produce a mismatch in tax outcomes of payments under such arrangements, thereby lowering the aggregated tax paid by both parties to the arrangements. Mismatches as a result of differences in the way two jurisdictions value money, such as gains and losses from foreign currency fluctuations, are not within the scope of the Report. Also, the hybrid mismatch rules are not applicable to payments that are only deemed to be made for tax purposes, such as unilateral deductions for invested equity. Moreover, the hybrid mismatch rules do not address differences in the timing of payments and receipts under the laws of different jurisdictions. As discussed, the Hybrid Mismatch Report limits the scope of the application of the recommended rules to more specifically stated circumstances, the so-called bottom up approach. As such, it contains a more robust section on definitions of terms that are important to the scope of the recommendations. The Report states that a structured arrangement is defined as any arrangement where the hybrid characteristic is priced into the terms of the arrangement or the facts and circumstances of the arrangement indicate that it has been designed to accomplish a hybrid mismatch. The Report provides a non-exhaustive list of facts and circumstances that indicate the existence of a structured arrangement: An arrangement that is designed, or is part of a plan, to create a hybrid mismatch An arrangement that incorporates a term, step or transaction used in order to create a hybrid mismatch An arrangement that is marketed, in whole or in part, as a taxadvantaged product where some or all of the tax advantage derives from the hybrid mismatch An arrangement that is primarily marketed to taxpayers in a jurisdiction where the hybrid mismatch arises An arrangement that contains features that alter the terms under the arrangement, including the return, in the event that the hybrid mismatch is no longer available An arrangement that would produce a negative return absent the hybrid mismatch The Report states that a taxpayer will not be regarded as a party to a structured arrangement when neither the taxpayer nor any member of the same control group could reasonably have been expected to know there is a hybrid mismatch and they did not share in the tax benefit resulting from such mismatch. Interestingly, the Report does not include the possibility for jurisdictions to provide safe-harbors to taxpayers, as hinted in the Discussion Drafts. For definitions of related persons and control group, the Hybrid Mismatch Report states that two persons would be related if they are in the same control group or if one person has a 25% or greater investment in the second person, or there is a third person that 3

4 holds a 25% or greater investment in both. This reflects a significant change from the 10% or greater threshold in the Discussion Drafts. 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. For purposes of the related party rules, a person who acts together with another person in respect to ownership or control of any voting or equity rights or interests will be treated as owning the other person s rights or interests. Acting together will be deemed to happen if (i) the persons are members of the same family; (ii) a person regularly acts in agreement with another person s wishes; (iii) the two persons have entered into an agreement that materially impacts the value or control of the interests; or (iv) the ownership or control of such rights or interests is managed by the same person or group of persons. Except for the first item, this appears to require an analysis of the underlying arrangement and conduct of the parties involved. The Report also provides that if the taxpayer is a collective investment vehicle (CIV), the presumption of acting together can be rebutted if, based on the terms and the circumstances of an investment arrangement, it can be demonstrated to the satisfaction of the relevant tax authority no such conduct is involved. In addition to the definitions pertinent to the scope of the recommendations, the Report dedicates a chapter to define key terms such as accrued income, CIV, deduction, distribution, income, payer, payee, taxpayer, etc. The Report states that the definitions are provided to ensure consistency in the application of the recommendations. The recommendations in general The Hybrid Mismatch Report categorizes the consequences of hybrid arrangements into two types of outcomes: (i) payments that are deductible under the rules of one jurisdiction but are not included in income under the laws of the other jurisdiction (the so-called deduction/no inclusion outcome, or the D/NI outcome ), and (ii) payments that give rise to multiple deductions in different jurisdictions on the same expenditure (the socalled double deduction outcome, or D/D outcome ). While the Hybrid Mismatch Report illustrates situations where a D/NI outcome may be achieved by using both hybrid instruments and/or hybrid entities, the Report only refers to hybrid entities when analyzing a D/D outcome. The Report also makes recommendations with respect to payments that produce indirect D/NI outcomes. Recommendations to neutralize arrangements that result in D/NI outcomes To neutralize arrangements that will yield a D/NI outcome, the Report makes five recommendations. In the context of the first recommendation, the Report defines a financial instrument as an arrangement that is taxed under the rules for taxing debt, equity, or derivatives under the laws of the payee and payer jurisdictions and defines a hybrid financial instrument as a financial instrument where payments are subject to a different tax treatment under the law of two or more jurisdictions. A hybrid financial instrument may be a so-called hybrid transfer, which is defined in the Report as any arrangement to transfer an asset entered into by a taxpayer and a counterparty whereby either the taxpayer is the owner but the rights of the counterparty are treated as obligations of the taxpayer, or the counterparty is the owner, and the taxpayer s rights are treated as obligations of the counterparty. 4

5 Hybrid financial instrument example: Payment by Issuer is treated as payment of deductible interest by Country B. Payment received by Parent is treated as exempt dividend income by Country A. The result is an interest deduction in Country B with no corresponding income inclusion in Country A. Hybrid transfer example: Country A treats the arrangement as loan from Holder to Issuer secured by shares of Target. Deduction for interest expense is permitted in Country A on the difference between sale and purchase price. Dividend income from Target is exempt from tax in Country A. Country B treats the arrangement as purchase and sale of Target shares. Dividends from Target and capital gain on Target shares are exempt from tax in Country B. The result is an interest deduction in Country A with no corresponding income inclusion in Country B. 5

6 Under the hybrid financial instruments rule, the primary domestic law response would be to deny the payer a deduction for a payment under a hybrid financial instrument to the extent of the D/NI outcome. The defensive rule would require a compulsory inclusion of the payment as ordinary income of the payee to the extent of the D/NI outcome if the payer jurisdiction does not have a rule in place to eliminate the mismatch. Importantly, the Report specifies that this rule would only apply to payments under a financial instrument (including a hybrid transfer) and its scope would be limited to financial instruments held by related parties or as part of a structured arrangement to which the payment relates. Further, the recommendation specifies that the primary response should not apply in certain defined circumstances that do not pose mismatch concerns. The Report states that the OECD will provide further guidance on the application of this exception. Furthermore, the Report makes clear that the rule should only apply when it is the terms of the instrument that cause a mismatch in the tax treatment of payments and the mismatch is not related to the non-ordinary status of the taxpayer (e.g., a tax-exempt entity). The second recommendation made by the Hybrid Mismatch Report with respect to hybrid financial instruments is to deny the dividend exemption (or other types of dividend relief granted to relieve economic double taxation) for dividend payments that are deductible to the payer. The Report states that this recommendation would better align tax outcomes on cross-border transactions and reduce the mismatches arising through the use of hybrid financial instruments. In addition, to prevent duplication of tax credits under a hybrid transfer, the Report recommends that any jurisdiction granting relief for taxes withheld at the source of a payment made under such an instrument should restrict the benefit of such relief to the net taxable income under such payment. It should be noted that the second recommendation is not limited in scope to a financial instrument entered into between related parties or where payments are made under a structured arrangement to which the taxpayer is a party. The third recommendation refers to disregarded payments that are defined for purposes of the so-called disregarded hybrid payments rule as a payment that is deductible under the laws of the payer jurisdiction but is not recognized under the laws of the payee s jurisdiction. Disregarded payments made by a hybrid entity to a related party example: Country A treats Payer as transparent. Interest income of Investor and interest expense of Payer are not recognized as income and expense, respectively, in Country A. Country B treats Payer as an entity. Deduction for interest paid in Country B that may reduce Payer Affiliate s country B taxable income through Country B loss-sharing or fiscal-unity regimes. The result is a deduction for interest in Country B with no corresponding income inclusion in Country A. The recommended rule calls for denying a deduction for such a payment to the extent that it gives rise to the D/ NI outcome. Under the recommended defensive rule, the payee jurisdiction would require such payment to be included in ordinary income. For the rule to apply, a mismatch must occur. Therefore, if a mismatch does not occur due to the deduction being set-off against income included in ordinary income in both the payer s and payee s jurisdictions (i.e., dual inclusion income), the rule will not apply. In that case, the recommendation calls for permitting any excess deduction (i.e., deductions that exceed the dual inclusion amount) to off-set subsequent dual inclusion income. 6

7 The disregarded hybrid payments rule will only apply when a hybrid payer makes a disregarded payment. A person is a hybrid payer if the tax treatment accorded to it by the laws of the payee s jurisdiction cause the payment to be disregarded. For example, a hybrid payer might be an entity that is disregarded as a separate entity from its owners under US tax rules or a tax transparent entity in a European jurisdiction. This disregarded hybrid payments rule is limited in scope to parties to a mismatch that belong to the same control group or where the payment is made as part of a structured arrangement to which the taxpayer is a party. The fourth recommendation looks to neutralize D/NI outcomes arising from payments made to a hybrid payee, which is usually a so-called reverse hybrid because it is treated as opaque for the investor jurisdiction and transparent under the jurisdiction in which it is established. Payment to a foreign reverse hybrid example: Country A treats Intermediary (a reverse hybrid) as an opaque entity. Interest income of Intermediary is not recognized as income by Investor in Country A. Country B treats Intermediary as transparent. Investor is not treated as having a permanent establishment in Country B. Country B does not impose tax on interest income of Intermediary. Country C treats Intermediary as transparent. Deduction for interest paid by Payer is allowed in Country C. The result is a deduction for interest in Country C with no corresponding income inclusion in either Country A or B. The recommended rule would be to deny a deduction for any payment to the extent it gives rise to D/NI outcome, provided such payment is made to a reverse hybrid entity and further provided that the mismatch occurs precisely because the payment is made to the reverse hybrid entity (i.e., the mismatch would not have happened if the payment had been received directly by the investor in the reverse hybrid entity). The scope of this rule is limited to any payer that is in the same control group as the parties to the hybrid mismatch or if the payment is part of a structured arrangement to which the payer is a party. Finally, the fifth recommendation contained in the Report is aimed at neutralizing D/NI outcomes by improving the CFC or other offshore tax regimes that do not specifically contemplate payments to a reverse hybrid and considering those regimes in relation to imported mismatch arrangements. The fifth recommendation additionally calls for modifying the domestic tax laws to insure that a reverse hybrid is treated as a resident taxpayer in the jurisdiction of organization if its income is not taxed in that jurisdiction and the accrued income of the nonresident investor is also not taxed under the laws of the investor jurisdiction. This fifth recommendation acknowledges the need to establish better tax filing or information reporting requirements on entities that may well be fundamental in accomplishing the mismatch, and it indicates that the Commentary to the Report expected 7

8 in late 2015 will provide circumstances in which such enhanced reporting is required. It further links this work to work being done under Action 12 on disclosure of aggressive tax planning. Recommendations to neutralize arrangements that produce a DD outcome The recommendations in this chapter of the Hybrid Mismatch Report deal with mismatch arrangements that result in a deductible payment made by a hybrid payer triggering a duplicate deduction under the laws of the parent jurisdiction. As explained in the Report, these arrangements usually involve a hybrid subsidiary that is treated as transparent under the tax laws of the investor and opaque in the jurisdiction where it is established. Basic double deduction structure using hybrid entity example: Country A treats Payer as transparent. Deduction is allowed for interest paid by Payer in Country A. Country B treats Payer as an entity. Deduction for interest paid in Country B may reduce Payer Affiliate s country B taxable income through country B loss sharing or fiscal unity regimes. The result is a deduction for interest expense in both Countries A and B. The recommended primary response rule is to deny a deduction for the investor on that payment to the extent that it gives rise to a DD outcome. Under the recommended defensive rule the payer jurisdiction would deny a deduction for such payment to the extent it gives rise to a DD outcome. Importantly, for the rule to apply, a mismatch must occur and no mismatch will occur to the extent the deduction is being set-off against income included in ordinary income in both the payer s and investor s jurisdictions (i.e., dual inclusion income). The Report recommends that deductions in excess of the dual inclusion income amount may be eligible to be set-off future dual inclusion income. In addition, to prevent stranded losses, the excess deduction may be allowed only if the taxpayer establishes to the satisfaction of the tax authority that the deduction cannot set-off income in another jurisdiction. The Report clarifies that this rule would only apply to a payment that results in a hybrid mismatch and is made by a hybrid payer; and either (i) the payer is a 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 (ii) 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 Report provides a scope limitation for the application of the defensive rule to parties in a control group or a structured arrangement. Notably, the Report provides no limitation on scope with respect to the primary rule. The next recommendation addresses payments by dual resident entities. Such payments are deductible under the tax laws of both jurisdictions of which the entity is resident. 8

9 Dual consolidated company example: Payer is a resident of both Countries A and B. Deduction is allowed for interest paid by Payer in Country A and may reduce Investor s Country A taxable income through Country A s loss sharing or fiscal unity regime. Deduction also is allowed for interest paid by Payer in Country B and may reduce Payer Affiliate s Country B taxable income through Country B s loss sharing or fiscal unity regime. The result is a duplicate deduction for interest expense in both Countries A and B. Under the dual resident payer rule, deduction for a payment made by a dual resident will be denied to the extent it gives rise to a DD outcome. The Report noted that as both jurisdictions apply the primary response, a defensive rule is not required. As in the previous rule, there will be no mismatch to the extent the deduction sets-off dual inclusion income. Similarly, deductions in excess of the dual inclusion income amount may be allowed to set-off future dual inclusion income. Again, to prevent stranded losses, the excess deduction may be allowed only if the taxpayer establishes to the satisfaction of the tax authority that the deduction cannot set-off income in another jurisdiction. Finally, the Report also clarifies that this rule would only apply to a payment that results in a hybrid mismatch and is made by a dual resident payer. Arrangements that produce indirect D/NI outcomes 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. 9

10 Importing mismatch from hybrid financial instrument example: In Country A, payment from Intermediary is treated as dividend and is exempt from tax in Country A. In Country B, Intermediary s payment to Investor is treated as interest expense. Such interest expense sets off interest income received from Payer. In Country C, interest paid by Payer to Intermediary is deductible in Country C. The result is a deduction for interest in Country C with no corresponding income inclusion in either Country A or B. Under the imported mismatch rule, the payer jurisdiction will deny a deduction for a payment made under an imported mismatch arrangement to the extent that the hybrid deduction is set-off against the payment in the payee jurisdiction. Under this rule, a hybrid deduction is defined as a deduction for: (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; (iv) a payment made by a hybrid payer or dual resident that triggers a duplicate deduction resulting in a hybrid mismatch; or (v) a payment made to a person that offsets the income from such payment against a deduction under an imported mismatch arrangement. As in most of the previous rules, 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. Part II: Recommendation on treaty issues Part II of the Hybrid Mismatch Report contains recommendations on changes to the OECD Model Tax Convention to be made to ensure that hybrid instruments and entities are not unduly used to obtain treaty benefits and to address treaty issues that may arise from the recommended domestic law changes. This Part II generally reflects the proposals in the Discussion Drafts. The first recommendation made is with respect to dual-resident entities. The Report makes a reference to the 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 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 State under that State s domestic law while, at the same time, being a resident of another State under a tax treaty concluded by the first State. This misalignment 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). Therefore, the Report 10

11 concludes that the solution must be changes to domestic law that would deny residency of an entity under domestic law if the entity is treaty as resident in another jurisdiction under the applicable income tax treaty. In this respect, the Report refers to two examples of such laws in Canada and the United Kingdom. The second recommendation addresses the use of transparent entities to unduly benefit from treaty provisions. In this respect, the Report recommends an amendment to Article 1(2) of the 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 fiscally transparent under the tax law of one of the Contracting States will be considered to be income of a resident only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State. 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 Commentary specifies that the rule with respect to the income affected (i.e., income derived by or through an entity or arrangement) is deliberately broad and covers any income earned through any entity or arrangement, regardless of the Contracting States views with respect to the personality or legal status of the person deriving the income. Likewise, the word income will have the same broad meaning as it does in other parts of the Convention. Finally, the Report states that fiscally transparent refers to situations where, under the Contracting State s law, the income is not taxed at the entity but at the interest holder s level. Lastly, Part II of the Hybrid Mismatch Report analyzes the possibility for potential conflicts between the recommendations contained in the Report and the provisions of the OECD Model Tax Convention. With respect to the rule providing for the denial of deductions, the Report notes that treaties do not govern whether a payment is deductible. Such decision is left to the domestic laws and therefore the rule recommended would not infringe any treaty provision. Furthermore, with respect to the defensive rules that require an inclusion of a payment as ordinary income, the Report asserts 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 state. However, for all the rules recommended in this 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, Article 23 A (Exemption Method) and 23 B (Credit Method) of the OECD Model Tax Convention which are directed at the State of residence. Article 23 A as it is worded in the OECD Model Tax Convention would not create problems to jurisdictions that adopt the recommendations made in Part I of the Hybrid Mismatch Report because it specifies that the credit method of Article 23 B of the OECD Model Tax Convention typically applies to dividends. However, the Report notes that a number of bilateral tax treaties depart from that and apply the exemption method with respect to dividends and provides general comments on how to resolve the problem. Likewise, Article 23 B is regarded as consistent with the recommendations in Part I of the Report. The only issue noted is circumstances under which 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 Hybrid Mismatch Report analyzes the potential application of anti-discrimination provisions in the OECD Model Tax Convention. However, as explained 11

12 in the Discussion Drafts, the OECD states that those concerns are more related with how the recommendations for domestic law will affect nonresidents, so the concerns would not appear to raise issues with respect to a potential conflict with the OECD Model Tax Convention. Implications The recommendations included in Hybrid Mismatch Report reflect the extensive input the OECD received from the business community and stakeholders. The Report limits the scope of the application of the hybrid rules to structured arrangements and related party transactions. The threshold for related party also was increased from 10% to 25%. The Report indicates that the OECD is continuing its work on Action 2 to address certain substantive and implementation issues. In this regard, the OECD intends to develop guidance on how the rules would operate in practice, including practical examples. The Report also notes that there are specific areas where the recommended domestic law rules may need further refinement. The two areas specified are the treatment of certain capital market transactions such as onmarket stock-lending and repos and the rules on imported hybrid mismatches (i.e., deduction/ non-inclusion outcome extended to a third jurisdiction by using intercompany loans). In addition, the OECD will further explore concerns raised by countries and business with respect to the application of the rules to intragroup hybrid regulatory capital. The OECD also will address the potential treatment of inclusions under CFC rules as included in income for purposes of the Report. Until work on the hybrid regulatory capital and CFC inclusion issues is completed and consensus reached, countries are free in their policy choices in these areas. It is important for interested stakeholders to continue to engage with the OECD and country policy makers as work on these technical issues and on the development of more detailed implementation rules continues into For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Barbara Angus Barbara.Angus@ey.com Yuelin Lee Yuelin.Lee@ey.com Maria Martinez Maria.Martinez@ey.com Ernst & Young LLP, Global Tax Desk Network, New York Gerrit Groen Gerrit.Groen@ey.com Daniel Brandstaetter Daniel.Brandstaetter@ey.com 12

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