Tax Brief. 24 March OECD Recommendations on Cross-border Hybrids. 1. Background

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1 Tax Brief 24 March 2014 OECD Recommendations on Cross-border Hybrids Another piece of the base erosion puzzle has appeared with the release of the OECD s recommendations for addressing cross-border hybrids. This Tax Brief analyses the 2 OECD Public Discussion Drafts on neutralising the effects of hybrid mismatch arrangements and their implications, both for Australia s future treaty practice and for some common cross-border structures and instruments. If these recommendations are pursued, Australia s tax law could become much more contingent, and structurally dependent on the policies and practices of other governments. 1. Background The wide-ranging OECD project on base erosion and profit shifting (BEPS) which emerged during 2013 listed 15 Action Items to be pursued during 2014 and One of the items listed in the OECD s Action Plan on Base Erosion and Profit Shifting (July 2013) involved developing measures to, neutralise the effects of hybrid mismatch arrangements. These measures (along with measures directed at CFC rules, interest deductibility and tax incentives), were intended to contribute to the broader goal of establishing, a fundamentally new set of standards designed to establish international coherence in corporate income taxation. The measures targeting hybrid arrangements were envisaged as having two distinct dimensions: possible revisions to the OECD Model treaty, to ensure that hybrid instruments and entities (as well as dual resident entities) are not used to obtain the benefits of treaties unduly. This aspect is explored in a 14 page document (the Treaty Draft) which proposes changes to the OECD Model treaty, and recommendations about domestic law changes to address the effects of mismatches. This aspect is explored in a 79 page document (the Domestic Draft). The need to pursue changes in domestic laws was acknowledged as necessary because the other alternatives trying to secure harmonisation of entity and transaction classification between countries, or invoking some kind of specific or general anti-avoidance rule would be less likely to succeed. 1 OECD Recommendations on Cross-border Hybrids

2 With regard to domestic law, the July 2013 Action Plan envisaged three potential changes: removing an exemption to the recipient where a payment is deductible by the payer for example, switching off the participation exemption for a payment which would ordinarily be treated as a dividend in the recipient country, but is treated as interest in the paying country; denying a deduction to the payer if a payment is not assessable income of the recipient (and is not subject to taxation under controlled foreign company rules or similar anti-deferral rules) for example, denying a deduction for a payment which would ordinarily be treated as interest in the paying country, but is treated as a dividend in the recipient country; and denying a deduction to the payer for a payment that is also deductible in another jurisdiction for example, denying a deduction to one of the companies involved if interest is being claimed as a deduction by the subsidiary and by the parent (typically through the effects of the US check-the-box rules). These approaches would make national tax laws much more contingent and inter-dependent. For example, interest might be deductible if paid to Country A but not if paid to Country B, or a dividend might be exempt from tax if received from a subsidiary resident in Country C but not if the subsidiary is resident in Country D. The domestic consequences would be driven by the treatment abroad from time to time. The July 2013 Action Plan recognised that it would be necessary to provide, guidance on co-ordination or tie-breaker rules if more than one country seeks to apply such rules to a transaction or structure. 2. The practical, conceptual and geo-political problem The driver of all cross-border mismatches in tax is different views between sovereign states about the best way to approach a particular situation, instrument or entity. Countries rarely consider alignment with the tax laws of other countries as an important policy objective when designing their own law. Australian tax law is full of instances of significant misalignment with other countries approaches to the same issue: our debt / equity rules are highly idiosyncratic, our tax consolidation system has many features that are unique, even among countries with consolidation systems, our formal conduit foreign income rules are uncommon (although other countries may achieve similar outcomes, in whole or in part, through a combination of rules), 2 OECD Recommendations on Cross-border Hybrids

3 our views about the circumstances when a partnership or a trust is, and can remain, transparent and when it is to be taxed as a company (Divisions 5A, 6B and 6C) are not likely to match the classifications that other countries are applying to these entities, our notion of the border between a lease and a sale with vendor finance will not always correspond with the border drawn by other countries, our treatment of fringe benefits formally taxes the wrong person and our approach to taxing personal services income that is diverted to entities or family members is not universally followed, our retirement income system adopts income tax treatment (taxed-taxed-exempt) while other countries commonly employ a consumption tax model (exempt-exempt-taxed), other countries may view a payment for the use of intellectual property simply as a royalty which we treat as including a payment for services or as involving such a significant limitation of owner rights that it amounts to a sale, and so on. A moment s reflection suggests the potential for cross-border mismatches is enormous. If the solution to mismatches lies in changes to the domestic law of a country, obvious questions include, which country is to change its treatment, will it agree to do so if change would adversely affect its revenue, if the change will increase its revenue, will the other country accept that outcome? Will there be a rush to get-in-first and what action will this provoke in response? The incentive for opportunistic and strategic behaviour is obvious. As will appear below, these recommendations can render domestic law subservient to the policy decisions of other governments. A recent article in the Financial Times put it this way: a leading tax expert described draft measures aimed at dismantling hybrid tax structures, which exploit differences between countries tax rules, as almost the tax world s equivalent of Big Bang. the proposals would allow foreign governments to block the check-the-box tax planning used by some US multinationals to route profits to tax havens, even without the co-operation of the US Congress. Surrendering sovereignty over tax matters to other countries is not something governments are used to, or are likely to enjoy. One would also have to wonder whether Australia would be a net winner or net loser from these measures one hopes Treasury has modelled these matters and knows the answer. If Australia would be a net loser, why would we act on these recommendations? In the same vein, will these measures increase the cost of capital for Australian companies? If so, is this a good idea and why? It is instructive that while the recent UK Budget included a statement supportive of the BEPS 3 OECD Recommendations on Cross-border Hybrids

4 project, it also reiterated the government s strategy of reforming the corporate tax system to create the most competitive tax environment in the G20, and ensuring that, the banking sector [is not] unfairly advantaged or disadvantaged by the introduction of these rules arising from the BEPS project. 3. March 2014 reports 3.1 Treaty issues With regard to changes to the OECD Model (and, it can be expected, Australia s future treaty practice) the Treaty Draft focuses on three issues: dual resident entities, transparent entities and reconciling the recommendations in the Domestic Draft with the terms of the OECD Model. Dual resident entities. The Treaty Draft repeats the proposal already made in the Discussion Draft on tax treaty abuse (which will be the subject of a separate Tax Brief), to replace the current tie-breaker rule in art 4(3) of the OECD Model for a person other than an individual. The current rule allocates the place of residence for treaty purposes exclusively to the place of effective management. The Treaty Draft proposes replacing that rule with a requirement that residence be resolved by the competent authorities on a case-by-case basis, having regard to a variety of factors place of effective management, place of incorporation and any other relevant factors. If the competent authorities are unable to agree, the entity is not entitled to any tax relief or exemption provided by the treaty. The Treaty Draft notes that this recommendation will not solve all dual residence problems. It will not solve the problem that the tie breaker rule only applies for the purposes of the relevant treaty. This means a company can be a resident of one country under its domestic law (and enjoy the benefits domestic law gives to a resident) while being a resident of the other country for the purposes of the treaty (and enjoy the benefits afforded by treaty to a resident of the other State). The Draft recommends that countries adopt, as a matter of domestic law, the position that a company which, is considered to be a resident of another State under a tax treaty will be deemed not to be a resident under domestic law. (A recommendation to this effect was made by the Board of Taxation in its 2003 report on Australia s international tax regime but the recommendation was never acted upon. Instead, Australian domestic law contains a targeted rule for prescribed dual residents which has an impact, among other things, on the CFC and consolidation regimes.) Transparent entities. One valuable output from this project is the proposal in the Treaty Draft that the OECD will amend the OECD Model to formalise the recommendations of the 1999 Partnerships Report, and extend it to other entities commonly treated as transparent such as trusts. The Treaty Draft recommends a simple clause which would treat the income earned by or through an entity that is viewed by either State as fiscally transparent as income of a resident provided it is taxed in the hands of a resident. Extensive passages explaining the effect of the new clause would be added to the Commentary to Article 1. Australia already has a rule of this kind in its 2009 treaty with New Zealand. 4 OECD Recommendations on Cross-border Hybrids

5 Reconciling the domestic proposals with the OECD Model. The Treaty Draft then examines whether there will be any tension between the recommendations for changes to domestic law in the Domestic Draft and the text of the OECD Model. There appears to be two concerns that the recommendations could challenge the paradigms currently embedded in the Treaty Draft, or that the domestic law changes could be rendered ineffective by the terms of the Model. The Treaty Draft concludes that: measures which would be implemented by denying deductions to a resident entity would not appear to offend the treaty, none of the measures being recommended appear to involve the imposition of tax on a non-resident with no permanent establishment in the State (which might have been a problem), the current drafting of the exemption method (art 23A) does not require amending, as it excludes dividends. However, countries whose treaty practice departs from the Model, and extend an exemption from tax to dividends received from a subsidiary in the other State, should change their practice employing a tax credit method for these dividends, the current drafting of the credit method (art 23B) does not require amending as the amount of the credit is already limited to the amount of tax payable after taking into account appropriate deductions, and none of the recommendations appear to involve practices that might invoke the non-discrimination provisions of the Model. 3.2 Recommended changes to domestic law The content of the Domestic Draft is not altogether unexpected it repeats much that was discussed in an earlier OECD document on Hybrid Mismatch Arrangements (2012). There has also been a parallel project undertaken by the European Commission on double non-taxation. The document proposes that States should enact rules described in the Domestic Draft in order to deal with the three identified targets, which give effect to some suggested solutions. What the rules would look like. The document sketches the rules a State should adopt in very general terms. They would be comprehensive and apply automatically. They would apply without the need to demonstrate that a State had lost revenue. No specific drafting is proposed but the document includes recommendations about the design, application and operation of three targeted rules: a hybrid financial instrument rule, a hybrid entity payments rule, and 5 OECD Recommendations on Cross-border Hybrids

6 an imported mismatches and reverse hybrids rule. Some of the rules would only be enlivened only for transactions between related parties. Targets. In order to get a sense of the transactions and structures these rules would attack and what their impact would be, it is necessary to look at the three targets. The Domestic Draft recommendations target three categories of hybrid mismatch arrangement: (a) (b) (c) Hybrid financial instruments (including transfers); where a deductible payment made under a financial instrument is not treated as taxable income under the laws of the payee s jurisdiction; Hybrid entity payments; where differences in the characterisation of the hybrid payer result in a deductible payment being disregarded or triggering a second deduction in the other jurisdiction; and Reverse hybrid and imported mismatches; which cover payments made to an intermediary payee that are not taxable on receipt. There are two kinds of arrangement targeted by these rules: (i) (ii) arrangements where differences in the characterisation of the intermediary result in the payment being disregarded in both the intermediary jurisdiction and the investor s jurisdiction (reverse hybrids); and arrangements where the intermediary is party to a separate hybrid mismatch arrangement and the payment is set-off against a deduction arising under that arrangement (imported mismatches). The meaning of these classifications is not self-evident and they receive more than a little explanation in the document. We discuss below some examples of each of these categories. Remedies. The document proposes that some of these measures would be addressed by multiple remedies a primary rule, one or more fall-back rules and (sometimes) information reporting. For example, for the hybrid financial instruments class (principally a dividend that is deductible to the payer and not assessable to the recipient) the document proposes: a primary rule, which would operate in the country where the payer resides, to deny a deduction to the payer, and a secondary rule, which would operate in the country where the recipient resides, which would include the dividend in the recipient s assessable income. This rule would only be triggered if the primary rule was not invoked by the country where the payer was resident. 6 OECD Recommendations on Cross-border Hybrids

7 (But there are also passages in the document which suggest that countries with a participation exemption should in any event modify their laws to exclude deductible dividends from the scope of the rule, in which case neither the primary nor the secondary rule would be needed.) However, the document then examines whether to restrict these rules in various ways for example, to remove from the scope of the rules plain vanilla loans or transactions involving individuals, to limit their operation just to transactions between related parties (or parties acting in concert) and to the parties to a structured arrangement, to exclude widely-held instruments or instruments that are traded on an exchange, and to exclude instruments that are hybrid instruments but which have hybrid features in order to satisfy the requirements of a financial system regulator. For the class of structure referred to as imported mismatches and reverse hybrids, the recommendation involves multiple remedies: a primary approach which would operate in the country where the owners reside: implementing CFC rules, FIF rules or targeted anti-avoidance rules or strengthening the existing regimes to tax the income accruing in a foreign jurisdiction on a current basis, a secondary rule which would operate in the jurisdiction where the intermediary was formed: requiring that jurisdiction to treat the entity as a taxpayer rather than as transparent, a third rule which would operate in the country from which amounts are paid to the intermediary: denying a deduction for those payments, and greater levels of information gathering and sharing required in the intermediary jurisdiction. 4. Implications for some structures and instruments We discuss below just how these approaches might be applied to some instruments and structures, and what the effect on Australian law might be. Example 1. Hybrid financial instrument rule inbound investment Dutch Co holds redeemable preference shares in Aus Co which qualify as debt interests for Australian tax purposes. Aus Co claims a deduction for the dividends it pays. Dutch Co is entitled to the benefit of the participation exemption and does not pay Dutch tax on the dividends it receives. 7 OECD Recommendations on Cross-border Hybrids

8 Dutch Co receipt treated as a dividend Diagram 1 NL AUS $ payment Aus Co payment treated as interest Under the proposed hybrid financial instruments rule, Australia would deny the deduction to Aus Co. If Australia failed to implement that rule, the Netherlands would deny Dutch Co the benefit of the dividend exemption. Of course, if the Netherlands changes its participation exemption so that deductible dividends are not entitled to tax relief, Australia would presumably allow the interest deduction. However, the relevant rule (presumably in both countries) might not be applicable if the companies were not related or the instrument was widely held etc. Example 2. Hybrid financial instrument rule outbound investment DOC ID Aus Co subscribes for a class of shares in a company resident in Country B (B Co) which represent a 10% interest in the company. Under the law of Country B, the returns on these particular shares are deductible in Country B. Under current Australian law, even though the instrument is regarded as a debt interest under Australia s debt / equity rules, the dividends on these shares are treated as non-assessable non-exempt income of Aus Co. Aus Co receipt treated as a dividend Diagram 2 AUS Country B $ payment B Co payment treated as interest Under the proposed hybrid financial instruments rule, Aus Co s entitlement to the dividend exemption would depend upon whether Country B retained or removed the tax deduction for B Co. If Country B retains the deduction, Australia would turn off the exemption; if not, Australia would permit the exemption to remain. Notice that if the proposal in the 2013 Budget (to limit the exemption only to dividends on instruments that are classified as equity under Australia s debt/equity rules) were subsequently implemented, there would be a different set of outcomes for B Co: Aus Co might no longer be entitled to a dividend exemption, which would mean that Country B should reinstate the tax deduction for B Co. 8 OECD Recommendations on Cross-border Hybrids

9 Example 3. Hybrid entity payments rule Aus Co is a company incorporated and resident in Australia, and the head entity of the Aus Co consolidated group (comprising Aus Co and its wholly-owned subsidiary, Aus Sub). Aus Co is a wholly-owned subsidiary of US Co and under the US check-the-box rules, Aus Co (but not Aus Sub) is a disregarded entity for US tax purposes. Aus Co borrows funds from Bank and pays interest on the borrowed funds. Aus Co (as head entity of the consolidated group) deducts the interest in Australia, in effect reducing the tax payable on the income of Aus Sub. In the US, US Co is regarded as the borrower and is entitled to deduct the same interest payment. US Co payer is USCo (which includes disregarded AusCo) Diagram 3 US AUS Aus Co $ interest Bank payer is AusCo group Aus Sub Under the proposed hybrid entity payment rule, the US would deny US Co a deduction for the interest to the extent it shelters Aus Sub s income from Australian tax. If, however, the US did not act to deny US Co the deduction, Australia would deny Aus Co a deduction for the interest payment. Other elements of the proposed rule try to adjust the outcomes if, for example, some of the income of Aus Co was being included in both countries simultaneously, and to allow the carry forward of losses if US Co could demonstrate to the IRS that the deduction it is being denied cannot be set-off against the income of any entity in Australia. Example 4. Reverse hybrid Aus Co is one of a number of investors in a corporate limited partnership (LP) in Country C. LP manufactures and sells products to an entity in Country D which then pays the price to LP. Under the laws of Country C, the income of LP is to be taxed in the hands of the partners (Aus Co and the other investors). Under Australian law, the entity in Country C, rather than the partners, is viewed as properly taxable on the income it receives (assuming LP is not a CFC and Aus Co has not made an election under s to treat LP as a foreign hybrid). 9 OECD Recommendations on Cross-border Hybrids

10 AUS Aus Co Australia views LP as proper taxpayer Diagram 4 other investors LP Country C views AusCo and investors as proper taxpayer Country C Country D $ price D Co Under the series of rules proposed for reverse hybrids some or all of the following should then occur: Australia should ensure its FAF rules would include in the assessable income of the Aus Co a share of the income of LP, if necessary, Country C should impose tax on the LP if the amounts it derives will not be taxed in the hands of Aus Co and the other partners, if necessary, Country D should deny a deduction for the price paid to LP, and Country C should gather substantial information from LP and make it available to Aus Co and the tax authorities in Australia. 5. Some comments Given how prevalent mismatches are, the document actually has quite a narrow focus. It does not purport to address all mismatches; instead, it is clearly preoccupied with just a few key issues in the current international tax order, principally disagreements about drawing the debt equity distinction and disagreements about entity recognition (eg check-the-box and consolidation systems). The paper does not address simple situations where a payment is deductible in one country at a relatively high rate (say 35% or 30%) and assessable in another country at a relatively low rate (say, 5% or 10%). Nor does the paper address situations where deductible payments may effectively be non-assessable because of the operation of an imputation/dividend franking system, such as the one we have in Australia. There are other indications in the document that it is not as ambitious as it might seem. Parts of the document convey mixed messages: 10 OECD Recommendations on Cross-border Hybrids

11 most of the discussion suggests these rules would operate for all transactions and structures; other parts suggest the rules would operate only between related parties, some of the discussion suggests that the rules are to be self-executing but other passages suggest they should only be triggered if revenue has been lost, some passages suggest that the rules should be triggered if there is either a permanent loss of revenue or simply deferral, although none of the examples presented in the paper involve instances of deferral, and while the rules are meant to be comprehensive, some things will be apparently be immune from attack. The example given is, rules that entitle taxpayers to a unilateral tax deduction for invested equity without requiring the taxpayer to accrue any expenditure (such as regimes that grant deemed interest deductions for equity capital) in other words, an allowance for corporate equity is meant to be immune from these rules even though it treats debt like equity and in one country only. These and other qualifications may possibly end up constraining the final scope of the project just to the most egregious and deliberate structures the kinds of structures which have been associated in the press and in parliaments with prominent players in the IT industry. 6. Next steps The two draft documents are being released for comment. Comments are due by 2 May A summary of the OECD s questions for consultation is attached as an Appendix to this Tax Brief. * * * * * 11 OECD Recommendations on Cross-border Hybrids

12 For further information, please contact Sydney Melbourne Perth Tony Frost phone Tim Kyle tim.kyle@gf.com.au phone Cameron Blackwood cameron.blackwood@gf.com.au phone Toby Eggleston toby.eggleston@gf.com.au phone Cameron Rider cameron.rider@gf.com.au phone Nick Heggart nick.heggart@gf.com.au phone G&F document ID _1.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney Melbourne Perth ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Collins Street, Melbourne VIC 3000, Australia Ph Fax QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax OECD Recommendations on Cross-border Hybrids

13 Appendix Summary of the OECD s questions for consultation 1 Design of Hybrid Mismatch Rules 1 Are the objectives and design principles of the hybrid mismatch arrangements clear? 2 If further clarification is required, then where is this required and how could it best be provided? 2. Hybrid Financial Instruments & Transfers 1 Is it clear what elements need to be present in order for the rules neutralising hybrid financial instruments or hybrid transfers to apply? 2 Is the outcome of the rules operation clear? 3 Are there any arrangements which should be caught by the rules but are not addressed in the recommendations? 4 This document sets out two possible approaches to drafting a scoping rule and summarises the possible advantages and disadvantages. Are the advantages and disadvantages accurately described and are there any other advantages and disadvantages of the two approaches? (a) What is the perceived impact of a bottom-up or top-down approach in terms of tax compliance and tax administration? 5 This part includes a number of examples: (a) (b) What commercial or legal difficulties might these examples give rise to where the parties to an arrangement are unconnected and have no knowledge of the counterparties position? In this context are there any examples or situations that are more problematic than others? If so please explain why problems arise and what constraints or restrictions the parties might face in obtaining relevant information on the treatment of the counterparty? 1 OECD Recommendations on Cross-border Hybrids

14 (c) (d) To the extent that there are difficulties, do these apply equally to both the holder and issuer in the context of hybrid financial instruments? Are there any other situations or examples, not covered here that give rise to difficulties? In particular are there any specific problems for regulated businesses (see also Q. 8 below)? 6 What definition could be used to capture the concept of widely-held or regularly traded whilst also addressing concerns that any exemption should not be available to related parties, parties acting in concert or parties to a structured arrangement (i.e. an arrangement designed to obtain the benefit of a mismatch). 7 If the rule exempted certain traded instruments then how could it be drafted so that it still applied to structured arrangements? 8 In relation to regulatory capital (a) (b) (c) What are the regulatory requirements for banks' to issue/manage capital at top holding company level, and what arrangements are used to pass this down the group? For example, what use is made of identical and traceable instruments and under what conditions would the arrangement be funded by a market issuance at top holding company level? Are special provisions needed to create parity between a banking group issuing hybrid regulatory capital indirectly to the market through its holding companies and a banking group (or another industry group) issuing hybrid regulatory capital directly to the market? Are hybrid regulatory capital instruments sufficiently different as to justify a full carve-out from hybrid mismatch rules? Are there inherent safeguards in place against the use of these instruments for tax-planning purposes or what safeguards could be introduced to ensure that any exemption from the general hybrid mismatch rules could not be abused? 3. Hybrid Entity Payments 1 Is it clear what elements need to be present in order for the rules neutralising deductible hybrid entity payments to apply? 2 Is the outcome of the rules operation clear? 3 Are there any arrangements which should be caught by the rules but are not addressed in the recommendations? 4 Are there any related party structures where the hybrid entity may have difficulty in knowing or obtaining information about the position of the investor? 2 OECD Recommendations on Cross-border Hybrids

15 9 If so when would these arise and what difficulties or constraints would the hybrid entity face? 4. Imported Mismatches and Reverse Hybrids 1 Are there any arrangements which should be caught by the rules but are not addressed in the recommendations? 2 Is it clear what elements need to be present in order for the defensive rule neutralising reverse hybrids and imported mismatches to apply? 3 How could an anti abuse provision be drafted so that it prevents otherwise unrelated parties from entering into arrangements to exploit mismatch arrangements? 5. Further Technical Discussion and Examples 1 Do these technical recommendations assist in understanding and applying the rules? 2 Are there further technical recommendations that should be addressed in the final report? Reference: Public Discussion Draft, BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements (recommendations for Domestic Laws), 19 March May 2014, page 78 see aft-domestic-laws-recommendations-march-2014.pdf 3 OECD Recommendations on Cross-border Hybrids