International Tax Alert - January 2016

January 2016

The United Kingdom Government releases draft legislation that will implement the agreed upon Organisation for Economic Co-operation and Development (“OECD”) recommendations for addressing hybrid mismatches.

Download PDF Version

The Organisation for Economic Cooperation and Development (OECD), a non-governmental forum established to promote economic growth, has developed a 15-point action plan to shape “fair, effective and efficient tax systems.” The OECD’s project regarding Base Erosion and Profit Shifting (BEPS) has addressed issues arising from tax planning strategies that exploit gaps or mismatches in member countries’ tax rules. 


On December 9, 2015, the United Kingdom tax authority, Her Majesty’s Revenue & Customs (“HMRC”), issued draft legislation that will implement the recommended rules for addressing hybrid mismatches as set out in the Final Report on Action Item 2: Neutralize the Effects of Hybrid Mismatch Arrangements (the “Final Report”) of the OECD/G20’s Base Erosion and Profit Shifting Project (the BEPS Project).  The measures will be included in the United Kingdom’s Finance Bill 2016, and will apply with effect from January 1, 2017.


Action Item 2 of the BEPS Project is designed to ensure that multinational companies can no longer benefit from the use of hybrid instruments or hybrid entities. The use of such hybrids has enabled multinational companies to avoid tax on income that would otherwise be included in taxable profit.
The draft legislation issued this month takes into account the responses received following consultation, further discussions with stakeholders, and the Final Report issued by the OECD in October 2015. 


The UK draft legislation follows the OECD’s recommendations closely and applies to seven types of hybrid arrangements. A brief summary of these arrangements are set forth below.
Deduction/non-inclusion mismatches
Four of the hybrid arrangements targeted fall within what is termed “deduction/non- inclusion” mismatches.  These are arrangements that include: hybrid financial instruments; hybrid transfers (e.g. repo/stock lending type arrangements); payments made by a hybrid entity payer; and payments made to a hybrid entity. 

In each case, where a payment or quasi-payment is made by a UK entity, the United Kingdom will deny a tax deduction to the extent that the income is not included in the taxable income of the recipient.  Where the payee is subject to UK tax and the payer jurisdiction has not implemented rules under BEPS Action 2, the United Kingdom will include the payment (that would otherwise not be taxed) in UK taxable profits. In that case, where the hybrid recipient is a UK Limited Liability Partnership (“UK LLP”), the United Kingdom will include the payment in UK taxable income as if the UK LLP were a UK resident company.

There are certain exclusions from the application of these rules, i.e., if there is a “permitted reason.”  Permitted reasons are when the recipient is a person not liable to tax on any profits or subject to tax that is not charged on foreign source income; or not liable to tax on the ground of sovereign immunity; or certain offshore funds and authorized investment funds.

It should also be noted that, generally, deemed deductions that arise only for tax purposes, e.g. notional interest deductions, should also be excluded. 

Double deductions
Two of the hybrid arrangements targeted involve double deductions.  These arrangements are when there is a double deduction in a hybrid entity or in a dual resident company.  Broadly, the rules apply to deny UK deductions where there is a deduction elsewhere for the same expense, and that deduction is not offset against income that is included in the taxable profits of both relevant territories.

Imported Mismatches
The last type of hybrid arrangement addressed was imported mismatches. This rule applies where there is a series of arrangements whereby a UK payer makes a non-hybrid payment to another entity and that entity, in turn, makes a payment to a third entity. If the payment to the third entity falls within any of the six hybrid arrangements listed above, the new UK rules will deny the non-hybrid deduction to the UK payer.
In each case above, the new rules apply to either related parties (which has a 25-percent threshold for capital, voting or value) or control group companies (which has a 50-percent threshold for capital, voting or value, or applies where companies are consolidated for accounting purposes), and to structured arrangements.

BDO Insights

The United Kingdom Government has fully embraced the agreed rules set out in the OECD’s Action Item 2 and these new rules will enter into effect for payments made on or after January 1, 2017. 

There will be no grandfathering of existing arrangements and there is no commercial purpose override as there is with the United Kingdom’s existing anti-arbitrage rules.  Although the new legislation will largely impact debt financing arrangements that make use of hybrid instruments or hybrid entities, other payments e.g. royalties, rentals or other expenses are within scope. The new rules will therefore present multinational companies with a significant challenge in maintaining a low effective tax rate if the use of hybrid techniques has been one of the principal means of lowering global taxes.

Groups with existing hybrid mismatch arrangements should consider now how they might restructure to be ready to enter into new arrangements before the commencement date of January 1, 2017. 

For questions related to matters above, please contact Ingrid Gardner.