Global Tax Alert | 7 April 2014

OECD releases discussion drafts on neutralizing hybrid mismatch arrangements under BEPS Action 2

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Executive summary

On 19 March 2014, the Organisation for Economic Cooperation and Development (OECD) released two Public Discussion Drafts in connection with Action 2 on hybrid mismatch arrangements under its Action Plan on Base Erosion and Profit Shifting (BEPS). The first document, BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements (Recommendations for Domestic Laws) (the First Discussion Draft) makes recommendations for domestic rules. The second document, BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements (Treaty Issues) (the Second Discussion Draft), discusses the effect those rules would have on the Model Tax Convention and proposes changes to the Convention to clarify treatment of hybrid entities. These Discussion Drafts are intended to provide stakeholders with proposals to be analyzed and commented.

The OECD is keen on obtaining public comments on any issue raised in the Discussion Drafts. In this respect, each Discussion Draft identifies specific issues for which comments are encouraged. Comments should be submitted by 2 May 2014.

Detailed discussion

The First Discussion Draft focuses on providing recommendations for domestic rules to be adopted by countries to neutralize the difference in tax treatments of hybrid mismatch arrangements. It describes previous reports issued by the OECD that discussed tax policy concerns with respect to hybridity, including the 2012 report, Hybrid Mismatch Arrangements. The First Discussion Draft also refers to work undertaken by the European Union, such as the European Commission's proposal to amend the Parent-Subsidiary Directive so that it would not apply to a profit distribution deductible by the subsidiary, as well as the ongoing work by the EU's Code of Conduct Group to create a general framework for hybrid mismatch rules that would apply to arrangements within the EU involving hybrid entities.

The First Discussion Draft previews the proposed amendments to the OECD Model Tax Convention to address issues relating to hybrid mismatch arrangements within the Second Discussion Draft. The Second Discussion Draft includes rules affecting income derived by or through a fiscally transparent entity or arrangement, and coordination of the domestic law solutions to hybrid arrangements so that potential conflicts are avoided.

The remaining parts of the First Discussion Draft sets forth general recommendations to the design of domestic law, and discusses three broad categories of hybrid mismatch arrangements. For each category, it provides detailed descriptions of arrangements and examples, specific recommendations of domestic law to be adopted, technical tax discussions, application and scope of the rules.

First Discussion Draft – recommendations for domestic laws


The First Discussion Draft defines hybrid mismatch arrangements generally as arrangements that utilize hybrid elements in tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to produce a mismatch in tax outcomes of payments made under those arrangements. The Discussion Draft clarifies that its focus is on hybrid mismatch arrangements that would result in a shift of profit between jurisdictions or that permanently erode the tax base of a jurisdiction.

Hybrid element refers to the mechanics of a specific arrangement that will yield a mismatch. Therefore, cross-border mismatches resulting from, for example, payments of deductible interest to a foreign tax-exempt charity are not addressed. There are two categories of arrangements that contain hybrid elements: hybrid entities and hybrid instruments. Issues arising with hybrid entities usually refer to the opacity of that entity for tax purposes. Issues arising with hybrid instruments may further be categorized into hybrid transfers, in which taxpayers in two jurisdictions take mutually incompatible positions on the character and ownership rights of an asset, and hybrid financial instruments, in which the incompatible treatments affects a payment made under the instrument.

The First Discussion Draft identifies two types of mismatch results. They are payments that are deductible under the rules of one jurisdiction, but are not included under the laws of another jurisdiction (the so-called D/NI outcome) and payments that give rise to duplicate deductions on the same expenditure (the so-called D/D outcome). Therefore, a mismatch occurs when inconsistent tax treatments apply to a payment.

Payment is defined in the First Discussion Draft as “an amount capable of being paid including (but not limited to) a distribution, credit, debit or accrual of money or money's worth.” It does not include payments made for tax purposes only or payments that do not create an economic relationship between the parties.

Finally, the payment that is made through a hybrid arrangement that causes a mismatch must erode the tax base of one or more jurisdictions where the arrangement is structured.

Criteria for a potential rule

The First Discussion Draft states 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;
  • Be comprehensive;
  • Apply automatically;
  • Avoid double taxation through rule co-ordination;
  • Minimize the disruption to existing domestic law;
  • Be clear and transparent in their operation;
  • Facilitate co-ordination with the counterparty jurisdiction while providing 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.

Design recommendations

The First Discussion Draft classifies the recommendations based on the particular hybrid techniques that produce BEPS outcomes. In this respect, the recommendations target three categories of hybrid mismatch arrangements:

  • Hybrid financial instruments (including transfers); for which 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, for which differences in the characterization of the hybrid payer result in a deductible payment being disregarded or triggering a second deduction in the other jurisdiction;
  • 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:
  • Arrangements for which differences in the characterization of the intermediary result in the payment being disregarded in both the intermediary jurisdiction and the investor's jurisdiction (reverse hybrids);
  • Arrangements for which 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).

For each of the categories listed, the First Discussion Draft recommends changes in domestic laws and linking rules – rules that link the tax treatment of an entity, instrument or transfer in one jurisdiction to the tax treatment in another jurisdiction – that specifically target the mismatch in tax outcomes under the particular hybrid arrangement. The linking rules, to be applied if domestic law fails to address the mismatch, are divided into primary responses and defensive rules for each category of hybrid mismatch arrangement. Primary responses generally refer to domestic rules in the payor's or investor's jurisdiction. Defensive rules generally refer to domestic rules in the payee's or subsidiary jurisdiction and apply in the absence of primary responses. Page 18 of the First Discussion Draft provides a summary of recommendations for easy reference.

Hybrid financial instruments and transfers

The First Discussion Draft defines a hybrid financial instrument as any financing arrangement that is subject to either different tax characterizations under the laws of two or more jurisdictions, such that a payment will have different tax treatments (e.g., a loan in one jurisdiction and equity in another), or different manner in which tax will be assessed on the instrument (e.g., deduction in one jurisdiction while the other jurisdiction gives an exemption). The different tax characterizations will result in a D/NI outcome.

In addition, the First Discussion Draft defines a hybrid transfer as a particular type of collateralized loan arrangement or derivative transaction under which the counterparties to the same arrangement in different jurisdictions would both treat themselves as the owner of the loan collateral or subject matter of the derivative. Similar to hybrid financial instrument, the difference in characterization will result in a D/NI outcome. Examples of various hybrid transfer arrangements, such as a “collateralized loan repo” arrangement, are provided in the Discussion Draft to illustrate the common elements in those arrangements.

In this respect, the First Discussion Draft suggests that ownership of an asset for tax purposes should be determined according to the beneficial ownership of the cash-flows associated with that asset and the mismatch should be neutralized by the linking rule for hybrid financial instrument, as discussed below.

The First Discussion Draft recommends jurisdictions enact a rule whereby a dividend exemption is only granted under domestic law to the extent the payment is not deductible by the payor. The Discussion Draft states that such a rule would eliminate mismatches in the first place. The First Discussion Draft also calls for changes to rules related to withholding tax rate relief granted at source. It states that relief should be proportional to the net taxable income derived under the arrangement.

The First Discussion Draft next describes the hybrid financial instrument linking rule. Under the primary response in the linking rule, the payor jurisdiction would deny a deduction for any payment made under a hybrid financial instrument to the extent the payee is not required to include the payment in ordinary income. Under the defensive rule, the payee jurisdiction would require inclusion in ordinary income to the extent the payor jurisdiction allows for a deduction (or equivalent relief) of the payment made under the hybrid instrument.

The First Discussion Draft recommends these rules only to target mismatches attributable to hybrid financial instruments, and to the extent of the mismatch. That is, the mismatch must result from the hybrid instrument itself, not the surrounding circumstances affecting the parties involved. In this respect, the rule only neutralizes the mismatches derived from that instrument, irrespective of whether, in the end, the taxpayer may not have increased tax liability because of the application of the hybrid financial instrument rule.

The First Discussion Draft recommends applying the hybrid financial instrument rule to any mismatch arising between related parties, including persons “acting in concert.” In this respect, the First Discussion Draft established that two persons are related if the first person has a 10% or more investment in the voting rights or value of a second or a third person has a 10% or more investment in vote or value in both.

For purposes of the related-party rule, a person who acts together with another person (acting in concert) in respect of ownership or control of any voting rights or equity interests will be treated as owning or controlling all the voting rights and equity interests of that person. Two persons will be treated as acting together if: (1) they are members of the same family; (2) one person acts in accordance with another's wishes regarding ownership or control of those rights or interests, or has entered into an arrangement to that end; or (3) the same person or group of persons manages ownership or control of those rights or interests.

Hybrid entity payments

The First Discussion Draft defines a hybrid entity payment as a technique to exploit differences in the treatment of an entity or arrangement across two jurisdictions to produce D/D or D/NI outcomes from payments made by that entity.

A D/D or double deduction outcome usually involves the use of a hybrid subsidiary that is treated as transparent in the investor's jurisdiction and not transparent in the jurisdiction where the entity is established or operates. The hybrid entity can be wholly owned, partially owned (e.g., an entity that is treated as a partnership in one jurisdiction and as a corporation in another) or certain other structures.

A double deduction technique can also be achieved by structures under which a single entity can be regarded as resident in more than one jurisdiction (e.g., dual consolidated companies). The entity can be consolidated with affiliated groups in different jurisdictions or could surrender losses to more than one affiliated group.

A D/NI outcome is usually accomplished when a hybrid entity makes a payment to its investor that is deductible in the payor's jurisdiction, but disregarded in the investor's. Some tax consolidation structures can also give rise to D/NI outcomes. The First Discussion Draft exemplifies these mismatches with arrangements in which a hybrid entity makes disregarded payments to a related party and a PE makes payments to a related party.

The First Discussion Draft establishes that the most direct way of addressing D/D outcomes would be to prevent double deductions from being used against any income that was not subject to tax in both jurisdictions (dual inclusion income). However, the implementation would be complicated, as it would not only require parallel rules in both jurisdictions designed to restrict the use of the deduction, but would also create compliance and information exchange issues.

Therefore, the First Discussion Draft recommends the following linking rule for deductible hybrid payments (i.e., payments that generate D / D outcomes). The primary response would deny the duplicate deduction arising in the investor's jurisdiction to the extent it exceeds the taxpayer's dual inclusion income for that period (with excess deductions being able to be carried forward). To prevent stranded losses, the excess duplicate deduction could be allowed in the investor jurisdiction, so long as the taxpayer can establish that the deduction for the hybrid payment is not being offset against the income of any person in the subsidiary's jurisdiction.

The defensive rule would deny the dual deduction in the subsidiary jurisdiction to the extent the deduction exceeds the dual inclusion income for the same period. Again, the First Discussion Draft recommends allowing carrying forward the excess unused deductions. Similar to the primary response, to prevent stranded losses, the excess duplicate deduction could be allowed in the subsidiary jurisdiction, so long as the taxpayer can establish that the duplicate deduction for the hybrid payment is not being off-set against the income of any other person in the subsidiary's jurisdiction.

For disregarded hybrid payments (i.e., payments that generate D / NI outcomes), the primary response would provide that the deduction allowed in the payor's jurisdiction for a disregarded payment should not exceed the taxpayer's dual inclusion income for the same period. The defensive rule, would require the payee to include, as ordinary income, any disregarded payments to the extent the payor's deductions for such payment in the payor jurisdiction exceed the payor's dual inclusion income for that period.

Imported mismatches and reverse hybrids

The First Discussion Draft last analyzes the mismatches that arise through the use of imported mismatch structures, including mismatches arising from the use of reverse hybrids. These mismatches give rise to D / NI outcomes. The First Discussion Draft, however, acknowledges that sometimes using a reverse hybrid will not result in a mismatch, because, in certain jurisdictions, the permanent establishment rule will affect the sourcing of the payment.

For imported mismatches, the First Discussion Draft distinguishes between imported mismatches using a hybrid instrument and imported mismatches using a hybrid entity.

The First Discussion Draft states that reverse hybrid and imported mismatch arrangements have a number of structural similarities, such as:

  • The arrangement will typically include at least three different tax jurisdictions (the payor jurisdiction, the intermediary jurisdiction and the investor jurisdiction).
  • The intermediary jurisdiction may have little incentive to apply a hybrid mismatch rule to the payment.
  • The hybrid element giving rise to the mismatch is a product of the investment structure between investor and intermediary. There is no hybrid element operating between payor and the intermediary and, accordingly, these structures can be used to generate D/NI outcomes for almost any cross-border payment regardless of the terms under which the payment is made, or the relationship between the payor and intermediary.
  • The structure of the arrangement can make it difficult for the payor to know the nature and extent of the mismatch unless it arises within the confines of a controlled group.

The mechanical difference between reverse hybrids and other types of imported mismatches turns on the nature of the hybrid mechanism and the mismatch in tax outcomes that is attributable to that hybrid mechanism.

  • In respect of reverse hybrid structures, the hybrid mechanism is the direct consequence of the hybrid tax treatment of the intermediary under the laws of the intermediary and investor jurisdiction and the resulting mismatch is a straight D/NI outcome in relation to a payment made to that entity.
  • In respect of other types of imported mismatches, both the hybrid mechanism and the mismatch is indirect, that is to say, the payment is offset or reduced by tax relief arising under another hybrid mismatch arrangement embedded in the arrangement.

The difference between reverse hybrids and imported mismatch arrangements could therefore be thought of as a difference between direct and indirect mismatches engineered through the investment structure.

The First Discussion Draft recommends that the investor and intermediary jurisdictions to implement comprehensive anti-hybrid mismatch rules to ensure the resulting mismatch could not be exported into a third jurisdiction. Such a solution, in which all countries had a harmonized response, would generate compliance and administration efficiencies, as well as certainty of outcomes for taxpayers.

The linking rule recommended by the First Discussion Draft calls for a primary response to be implemented in the investor's jurisdiction that would make changes to its controlled foreign corporation (CFC) or foreign investment fund (FIF) rules, or specific changes to domestic laws, that would target areas such as income of residents accrued through offshore investment structures and changes that would be effective to tax on a current basis. In addition, the Discussion Draft calls for a secondary rule that would apply to the intermediary jurisdiction and would deny transparent or partially transparent treatment to an entity of the intermediary jurisdiction if the controlling investor treats the intermediary as a reverse hybrid where income of the intermediary is not taxed under neither the investor's nor the intermediary's jurisdiction.

The defensive rule would apply in the payor jurisdiction and would deny a deduction for a payment to an offshore non-inclusion structure (i.e., reverse hybrid or imported mismatch) to the extent the payment results in no-taxation or is off-set by an expenditure incurred under a hybrid mismatch arrangement and the taxpayer is member of the same group as the parties to the arrangement resulting in the mismatch.

The First Discussion Draft also states that information reporting requirement also should be enacted in the intermediary jurisdiction to facilitate tax compliance and enforcement.

Second Discussion Draft – treaty issues

The Second Discussion Draft focuses on the changes that should be made to the OECD Model Tax Convention (Convention) in addressing Action 2. The Discussion Draft specifies that it complements the First Discussion Draft and it is intended to ensure that hybrid instruments and entities are not unduly used to obtain treaty benefits. Similarly, the document notes that special attention is to be given to possible discrepancies between the Convention and domestic laws that would have been modified under the recommendations of the First Discussion Draft.

The first change concerns dual-resident entities. In this respect, the Second Discussion Draft suggests that the recommendations should be included in Action 6 (Preventing Treaty Abuse), as strategies affecting the different definition of residence under the Model Tax Convention and domestic laws are better addressed in the Action for Treaty Abuse.

The second proposed change would address the use of transparent entities to unduly benefit from Treaty provisions. In this respect, Article 1(2) of the Convention is modified to include a rule for 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 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.

This change would include additions to the Commentary. The Commentary focuses on applying the rule to partnerships, but suggests that the Committee of Fiscal Affairs is willing to examine the application of that rule to entities other than partnerships at a later stage.

The Second Discussion Draft next comments on the necessity of coordinating with the First Discussion Draft and how the suggested domestic law changes may affect specific Articles of the Convention. For rules providing for the denial of deductions under domestic law, the Second Discussion Draft notes that, other than Articles 7 and 24 (which apply to Business Profits and Non Discrimination), nowhere in the Convention are deductions addressed.

Regarding the elimination of double taxation, which is suggested with the dividend exemption disallowance when the dividends are deductible in the source state and the special withholding rule recommended, the Second Discussion Draft notes that no Article in the Convention would conflict.

Article 23(1), as worded in the Model Convention, would not create problems to jurisdictions that adopt the recommendations made in the First Discussion Draft because it specifies that a credit method will apply to dividends. However, the OECD notes that a number of jurisdictions depart from that and agree on an exemption method, and provides general comments on how to resolve the problem.

Likewise, Article 23(2) is regarded as consistent with the recommendations in the First Discussion Draft. The only issue noted is circumstances under which the parties to the treaty either supplement or depart from the basic credit approach of the Convention of Article 23(2).

Finally, the First Discussion Draft seems to note concerns on potential application of anti-discrimination provisions in the Convention. The Second Discussion Draft acknowledges the concerns and states that those concerns are more related with how the recommendations in the First Discussion Draft will affect nonresidents, so the concerns would not appear to raise concerns about possible conflict with the Convention.


The two Discussion Drafts are the first drafts of the output to be produced under Action 2 of the OECD BEPS project. The Discussion Drafts contains detailed descriptions and examples of various hybrid mismatch arrangements and related recommendations on changes to domestic law and treaty provisions. Most notably, the application of the rules discussed generally would exclude unrelated parties, except for structured transactions. On the other hand, the implementation of these rules could require a multinational corporation to document the tax treatments of each cross-border intercompany transaction in two or more jurisdictions, which could significantly increase compliance cost.

Companies should evaluate how these proposed changes may affect them, stay informed about legislative and treaty developments in the OECD and in the countries where they operate or invest, and consider participating in the dialogue regarding the BEPS project and the underlying international tax policy issues.

A more detailed version with diagrams can be found under the download pdf link.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax services, Washington, DC
  • Barbara Angus
    +1 202 327 5824
  • Yuelin Lee
    +1 202 327 6378
  • Maria Martinez
    +1 202 327 8055
Ernst & Young LLP, International Tax services, New York
  • Gerrit Groen
    +1 212 773 8627

EYG no. CM4336