Base Erosion Profit Shifting (BEPS)- Action 2 Report- Neutralise Hybrid Mismatch Arrangement

Base Erosion Profit Shifting (BEPS)- Action 2 Report

Neutralise Hybrid Mismatch Arrangement

The OECD Committee on Fiscal Affairs approved the Base Erosion Profit Shifting (BEPS) action plan at their meeting in June, 2013, which was subsequently endorsed by G-20 Finance ministers.

They identified 15 Action plan to combat BEPS and OECD take upon itself to come with report on each action plan within definite time frame

Among 15 Action plan, Action 2 call for neutralising the Effects of Hybrid Mismatch arrangement in following manner:-

1.       Action 2 report recommends two actions to neutralise Hybrid Mismatch arrangement

a)      Recommendations regarding design of domestic rules.

b)      Recommended changes to OCED Model Tax Convention

2.       The Process behind recommendations for domestic rules are as under:-

a)      The design for domestic rules is based on linking rules, whereby proposed rule seek to align the tax treatment of instrument or entity with tax outcomes in the counterparty jurisdiction.

b)      To avoid double taxation and to ensure that mismatch is eliminated even where not all jurisdiction adopt the rules, the recommended rules are divided into primary response and defensive rule.

c)       The defensive rule only applies where there is no hybrid mismatch rule in other jurisdiction or the rule is not applied to the entity or arrangement in that jurisdiction.

3.       After this report, OCED will further issue guidance in the form of commentary, which will explain how rules will operate in practice  including  through practical examples

What is Hybrid Mismatch Arrangement

Hybrid Mismatch arrangement

·         It is an arrangement that

·         exploits a difference

·         in the tax treatment of an entity or instrument

·         under the laws of two or more jurisdiction

·         to produce mismatch in tax outcome

·         where that mismatch has the effect of lowering aggregate tax burden of the parties to the arrangement

Focus of Action 2 Report

·         The focus is on arrangement

·         that exploits  difference

·         in the way cross border payments are treated for tax purpose

·         in the jurisdiction of payer and payee

·         and to the extent such difference in treatment results in mismatch

Thus Action 2 report does not deal each and every possible arrangement designed to produce mismatch in tax outcome but deals only with cross-border payments which produce mismatch in tax outcome.

Example

Dual Resident Company concept, a Hybrid Structure, is used to organise the payment transaction in such a way so achieve Hybrid mismatch arrangement. Refer case 2- dual resident company on page 7, which is purported to curb by Action2 Report

But some time the Dual resident structure is also used to achieve tax avoidance explained as under:-

The Dual Residency of an entity, other than Individual, can be broadly divided into2 categories

Category 1 – Residential status Under DTAA is based on Tie- Breaker Rule (Article 4(3))

a)      Entity is resident of Domestic state based on Incorporation.

b)      Entity is also resident of foreign state based on management.

c)       Residential status under both the states is fulfilling the Criterion for determination of Residential Status under Article 4(1) of OCED model tax convention. ( i.e by reason of his domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature)

d)      Thus Tie Breaker Rule under Article 4(3) is used to determine residential status of Entity under DTAA

Category 2- Residential Status under DTAA is based on basic Article 4(1).

a)      Entity is resident of domestic state based on any criterion not falling within the criterion specified in Article 4(1) of DTAA i.e Based on residential status of majority of shareholders (assumed)

b)      Entity is also resident of foreign state based on management.

c)       In such case, entity is resident of domestic state under its taxation law but will be resident of foreign state under Article 4(1) of DTAA.

Example 1- Dual Residential status under above-mentioned category-1 

Suppose Indian company is being wholly managed from branch outside India (Say Country “x”) and partly activities are carried in Country X:-

The relevant legal provisions are as under:-

a)      Resident Status of Company in X Country - A company is said to resident in X country, if the control and management of its affairs is situated wholly in X Country.

b)      The relevant clause of DTAA with X relating to Resident clause provides as under:-

“Where by reason of the provisions of paragraph 3(1) of this Article a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident of the Contracting State in which its place of effective management is situated.”

Implications:-

1.       Such Company is treated as Resident of India under Income Tax Act 1961, as the company is incorporated In India

2.       Such company is also treated as resident of X under domestic law of country X

3.       Thus company is having dual residential status in India and Country X.

4.       As a result of Tie-breaker rule stated above, Company is treated as resident of Country X for DTAA purpose.

Mismatch arrangement

·         Suppose branch in Country X  earns substantial profits, which it refuse to offer for tax in India on account of following reasoning

1.       Company is resident of X under DTAA.

2.       Article 7 allocates rights to Tax business profits of X resident as under:-

a)      The Business profit of X resident will taxable in X alone.

b)      If X resident carries on business in India through PE, then profit attributable to such PE will be taxable in India

3.       Since Company is resident of X under DTAA, no profit from X is taxable in India.

·         Suppose Branch in Country X incurs losses, which company want to set-off against Profits in India on account of following reasoning

1.       As per, Section 90 of Income Tax Act, the provisions of DTAA is applicable to the assessee to the extent they are more beneficial as compared to IT Provisions.

2.       Section 6 provide that Resident of India is liable to tax in India on its global Income (Including losses)

3.       Since in the instant case, it is beneficial to assessee to include loss of foreign branch with Indian office, assessee will go for section 6 provisions without taking recourse to DTAA.

4.       Company will like to include branch losses in computing assessable income in India.

Example 2- Dual Residential status under above-mentioned category-2 

Suppose Company PQR in A Country is resident therein based on residential status of its majority of shareholders and Resident of Country B, from where the company is wholly managed and partly operations are carried in Country B.

Implications

a)      PQR is resident of Country A for its taxation purpose

b)      PQR is resident of Country B for the purpose of DTAA between A & B

Mismatch arrangement

1.       Profits in Country B will not be offered for tax in Country A, since as per provision of DTAA, Country A does have right to tax profit of resident of Country B from activities carried in Country B

2.       Loss in Country B will be offered to off-set against profits in Country A, since country A taxation rules tax income of its resident on global basis including negative income outside country A.

The recommendations suggested in Action 2 reports also intended to cover the mismatch tax outcome on account of dual residency in category 1 but not in category 2, explained later on. Refer page 8

Action 2 report identified two types of Hybrid mismatch arrangement as under:-

1.       D/NI (Deductible/No Inclusion) – Mismatch when proportion of a payment that is deductible under laws of one jurisdiction does not correspond to the proportion that is included in ordinary income by any other jurisdiction. Difference in value of payment due to foreign currency fluctuation is not intended to cover here

2.       D/D (Double Deductible) – Mismatch when all or part of payment is deductible under laws of two jurisdictions.

Action 2 report identifies broadly two Modes-operandi to achieve Hybrid Mismatch arrangement as under:-

1.       Hybrid Entities – Arrangement involving use of Hybrid entities i.e. same entity is treated differently under laws of two jurisdiction, which leads to different characterisation of a payment under laws of two jurisdiction

2.       Hybrid Instrument  - Arrangement involving use of Hybrid Instrument i.e. same instrument is treated differently under laws of two jurisdiction, which leads to different characterisation of a payment under laws of two jurisdiction

Report’s Recommendation for design of Domestic Rules

The recommendation of Report is in following manner

1.       D/NI mismatch – Hybrid Instrument

2.       D/NI mismatch – Hybrid Entity

3.       D/D mismatch- Hybrid Entity

D/NI mismatch – Hybrid Instrument

Case- 1- Hybrid Instrument

a)      2 entities involved - A Co (In country A) & B Co (In Country B)

b)      Transaction - B Co. Issue Hybrid Financial Instrument to A Co.

c)       Possible Hybrid Mismatch

i)                    The instrument is treated as Debt in Country B and it grants deduction for interest under instrument.

ii)                   Country A does not tax interest payment or grant some form of relief in relation to interest payment received under that Instrument.

iii)                 This mismatch in treatment of interest payment can also be due to the reason that Issuer Company treats the instrument as debt while Investment Company treats the instrument as equity.

Case- 2- Hybrid Transfer

a)      3 Entities involved – A Co (in country A), B Co (In Country B), B1 Co (In country B, a subsidiary of A)

b)      Transaction -  A co sells shares of B1 Co to B Co under an arrangement that A Co will acquire the shares of B1 Co at future date  for an agreed price.

c)       Possible Hybrid mismatch

i)                    A Country-   The difference between sale price and purchase price is treated as deductible financing cost.

ii)                   B Country – It grants exemption or some other form of relief to B Co in respect of dividend received from B1 Co. Further Capital gain accruing to B Co on sale of B1 Co shares is also exempted under capital gains

d)      The combined effect of repo transaction (sale & Purchase by A Co) is to generate deduction for A Co.  with no corresponding inclusion for B Co.

Recommendations 1 –Hybrid Financial Instrument Rule

1.       Neutralise the mismatch to the extent payment give rise to D/NI outcome

a)      Response – Deny the Deduction

The payer jurisdiction will deny deduction for such payment to the extent it gives rise to D/NI Outcome

b)      Defensive rule – Require the payment to be included in ordinary income

If the payer jurisdiction does neutralise the mismatch, then payee jurisdiction will require such payment to be included in ordinary income to the extent the payment give rise to D/NI outcome

c)       Timing Difference

Difference in the timing of recognition of payments will not be treated as giving rise to D/NI outcome

2.       Rule only applies to payment under financial Instrument

3.       Rules only applies to payment that results in Hybrid mismatch

4.       Scope of Rule

This Rule will apply to financial instrument entered into with a related person or where payment is made under structured arrangement and the taxpayer is party to that structured arrangement

5.       Exceptions to Rules

There are certain exceptions on which afore-said rules will not be applicable

Recommendations 2 – Specific recommendations for the tax Treatment of Financial Instruments

1.       Denial of Dividend exemption for deductible payment

In order to prevent D/NI outcome arising under financial instrument, a dividend exemption that is provided for relief against economic double taxation should not be granted under domestic law, to the extent dividend payment is deductible by payer

2.       Limitation of tax credit for tax withheld at source

D/NI mismatch – Hybrid Entity

Case 1- Disregarded Hybrid Payment

1.       2 Entities Involved – A Co (in A country) and B Co (In Country B and is Wholly owned Subsidiary (WOS) of A Co)

2.       Law in A Country – B Co is treated as Transparent in Country A  (i.e from Country A perspective income of B Co is taxable in the hands of Shareholders). Since A is 100% shareholder in B Co, Country A disregards the separate existence of B Co.

3.       Transaction – B Co borrows from A Co and interest is paid thereon.

4.       Possible Hybrid mismatch

i)                    Country A – Interest income of A Co is not taxable since the same is from Transparent entity. (For example payment Branch to HO is not income for HO)

ii)                   Country B – B Co is allowed to be consolidated with its subsidiary in B country for tax purpose and interest expense of B co is allowed to be set-off against income of subsidiary

Recommendations 3 – Disregarded hybrid payment rule

1.       Neutralise the mismatch to the extent payment give rise to D/Ni Outcome

a)      Response – Deny the deduction

The payer jurisdiction will deny a deduction for such payment to the extent it gives rise to D/NI outcome

b)      Defensive Rule – Require the payment to be included in ordinary income

If payer jurisdiction does not neutralise the mismatch then the payee jurisdiction will require such payment to be included in ordinary income to the extent payment give rise to D/NI outcome

c)       Mismatch does not arise to the extent the deduction is set-off against dual inclusion income

d)      Treatment of excess deduction

Any deduction that exceeds the amount of dual inclusion income, may be eligible to be set-off against dual inclusion income in another period

2.       Rule only applied to disregarded payment by Hybrid payer

3.       Rule only applies to Hybrid mismatches

A disregarded payment by hybrid payer results in a hybrid mismatch if, under the laws of payer jurisdiction, the deduction may be set-off against income that is not dual inclusion income

Case 2- Reverse Hybrid

1.       3 entities Involved – A Co (in Country A) , B Co  (In Country B and WOS of A) & C Co (In country C)

2.       Tax Law of A Country  (Investment Jurisdiction)– Treat B Co as separate Entity

3.       Tax law of B Country  (Establishment Jurisdiction)– Treat B co as Transparent entity, that income of B Co is not taxable at entity level but at the shareholder/partner level

4.       Transaction – C  Co. borrow from B Co and made payment of Interest under loan

5.       Possible Hybrid mismatch

a)      C Country (Payer Jurisdiction)- Interest is deductible in the hands of C Co.

b)      B Country – Interest is not taxable , as B Country treats the interest as income of state where investor is resident i.e A country

c)       A country- Treat the interest as income of state, where Establishment is resident i.e B

6.       Thus C Co is able to claim deduction of interest but the same is not taxable as Interest income in the hands of either A Co or B Co.

Recommendation 4- Reverse Hybrid Rule

1.       Neutralise the mismatch to the extent payment give rise to D/NI outcome

a)      Response – Deny the Deduction

The payer jurisdiction will deny a deduction for such payment to the extent it give rise to a D/NI outcome

2.       Rule only applies to payments made to a reverse hybrid

A reverse Hybrid is any person that is treated as separate entity by a related investor and as transparent under the laws of establishment jurisdiction

DD mismatch – Hybrid entities

Case 1- Deductible Hybrid Payment

1.       2 Entities Involved – A co (in A country) and B Co (in Country B and WOS of A)

2.       Tax laws of A- B co is treated as transparent Entity

3.       Transaction-B Co borrow Loan from bank and Pay interest

4.       Possible Hybrid mismatch

a)      A country (Parent Jurisdiction) – since B co is treated as transparent under laws, A Co is treated as borrower under loan from bank and interest is allowed as deduction to A Co.

b)      B Country (Payer Jurisdiction)

i)                    B Co is allowed as deduction of interest of loan from  bank

ii)                   In B country, for tax purpose B Co is consolidated for tax purpose with its Subsidiary and Interest of B Co is allowed to set-off against Income of subsidiary

5.       This interest on bank loan is allowed as deduction in Country A and B .

Recommendation- 6 – Deductible Hybrid payment Rule

1.       Neutralise the mismatch to the extent payment give rise to DD outcome

a)      Response – Deny the deduction in parent jurisdiction

The parent jurisdiction will deny the duplicate deduction for such payment to the extent it gives to DD outcome

b)      Defensive rule – Deny the jurisdiction in payer jurisdiction

If the parent jurisdiction does not neutralise the mismatch, the payer jurisdiction  will deny deduction for such payment to the extent it give rise to DD outcome

c)       Mismatch does not arise to the extent the deduction is set-off against dual inclusion income

2.       Rule only applies to deductible payments made by a Hybrid payer

3.       Rule only applies to payment that results in Hybrid mismatch

A payment results in hybrid mismatch where the deduction for payment may be set-off under the laws of payer jurisdiction, against income that is not dual inclusion income.

Case 2- Dual resident company

1.       3 entities involved – A Co (in country A) , B Co (in country B and WOS of A ) and B1 co (in country B and WOS of B)

2.       Tax laws of A – B Co is resident of Country A also. For Tax purpose B co is consolidated with A

3.       Tax Laws of B Country – B Co is resident of B Country and for tax purpose B Co is consolidated with B1 Co.

4.       Transaction – B Co borrow from bank and pay interest on loan and B Co has no other income

5.       Possible Hybrid mismatch

a)      Country A – Since B Co is consolidated with A Co for tax purpose, interest of  B Co is set-off against A co Income

b)      Country B – Since B Co is consolidated with B1 Co for tax purpose, interest of B co is set-off against B1 Co Income

6.       Thus Interest on bank loan is allowed as deduction in Country A and B

Recommendation – 7 – Dual Resident Payer Rule

1.       Neutralise the mismatch to the extent payment gives rise to DD outcome

a)      Response – Deny the Deduction in resident Jurisdiction

Each resident jurisdiction will deny a deduction for such payment to the extent it gives rise to a DD outcome.

b)      Rule does not apply to the extent deduction is set-off against dual inclusion income

No mismatch will arise to the extent that the deduction is set-off against income that is included as ordinary income under the laws of both jurisdiction (Dual Inclusion income)

c)       Treatment of Excess Deduction

Any deduction that exceeds the amount of dual inclusion income, may be eligible to set-off against dual inclusion in another period

2.       Rule only apply to deductible payments made by dual resident

3.       Rule only applies to payments that results in Hybrid mismatch

Report Recommendation for Treaty Issues

Action 2 Report recommends two treaty modifications as under

1.       Relating to Dual Resident Entities – Modification of Article 4(3) of OECD Model Convention

2.       Relating to Transparent Entities – Modification of Article 1 of OECD Model Convention

It was also acknowledged that modification of other treaty provision in other action reports may play important role in ensuring that Hybrid Instrument and entities are not used to obtain the benefits of treaties unduly

Dual Resident Entities

Action2 report recommends replacement of existing article 4(3) with new article

Existing Article 4(3) provides tie breaker rule in case of dual resident entities, other than individual, on the basis of place of effective management of entities.

Proposed Article 4(3)

“Where by reason of the provisions of paragraph 1 , a person other than an individual is resident of both contracting states, the competent authorities of contracting states shall endeavour to determine by mutual agreement the contracting state of which such person shall be deemed to be resident for the purpose of convention, having regard to its place of effective management, place where it is incorporated  or otherwise and any other relevant factor. In the absence of any agreement, such person shall not be entitled to any relief or exemption from tax provided by this convention except to the extent and in such manner as may be agreed upon by competent authorities of contracting states”

Thus OECD model tax convention proposes to determine residential status under DTAA in case of dual residency based on mutual agreement between contracting states, rather than based on place of effective management.

Proposed Prevention of Tax mismatch

This determination of residential status will be able to curb tax mismatch outcome under category 1 explained initially. Refer Page 2 above

Transparent Entities

Action2 report recommends replacement of existing article 1 with new article

The reason behind propose replacement is to ensure that benefits of tax treaties are granted in appropriate cases to transparent entities but also that these benefits are not granted where neither contracting states treats, under its domestic law, the income of an entity as income of one of its residents.

Existing Article 1 provides as to whom provisions of DTAA will be applicable

Now OCED propose to replace Existing Article 1 with new Article 1 as under

Article 1(1)

This convention shall apply to person who is resident of one or both of contracting states

Article 1(2)

 For the purpose of this convention, income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the laws of either contracting states shall be considered to be income of resident of contracting state but only to the extent that the income is treated, for the purpose of taxation by that state, as income of resident of that state. (In no case, shall the provision of this paragraph be construed as to restrict in any way a contracting state’s right to tax the resident of that state)

The reason behind the above article 1(2)  is explained as under through following illustration

Facts

1.       A Co resident of Country A lends money on interest to B, being partnership in B Country.

2.       A local tax laws provide for withholding tax of 30% on payment of interest to Non-resident

3.       B is having two equal partners- X, resident of B Country and Y, non-resent of B Country

4.       B Country treat partnership as transparent entity

5.       There is DTAA between country A and B, which provides following relevant clause

i)                    DTAA will be applicable to person who are resident of either A or B

ii)                    Person includes an individual, a company, a body of persons and any other entity which is treated as a taxable unit under the taxation laws in force in the respective Contracting States

iii)                 Resident means person who is liable to tax therein by reason of residence, domicile, place of management

iv)                 Interest arising in contracting state and paid to resident  of other state shall also be taxable in contracting state in which it arise @ 10%

Issue

1.       At what rate Country A withheld tax on interest paid to B i.e 10% or 30%

Existing DTAA position

Since B is not taxable unit in Country B and hence not resident as per DTAA, B cannot avail the benefits of DTAA and Country A will withheld tax @ 30% on interest paid to B

Post Amendment in Article 1

1.       B’s only one partner (50% shares) is resident of B Country

2.       Only 50% of interest income of B is treated as income of Resident of B Country

3.       B can avail DTAA benefit to the extent of 50% of Interest Income

4.       A  Co will withheld tax on interest income as under;-

a)      30% on 50% of Interest Income under provision of A country tax laws

b)      10% on 50% of interest income under DTAA

I hope OCED will further come with detail guidelines and example how such amendment will assist in neutralising Hybrid mismatch arrangement.