Tax Analysts®Tax Analysts®

My Subscriptions:

Featured News

February 10, 2014
News Analysis: What's in the OECD BEPS Hybrid Draft?
by Lee A. Sheppard

Full Text Published by Tax Analysts®

Women like fashion for the same reason they read horoscopes. They want a sense of renewal. They want tomorrow to be better than today. Of course, for most women in most of the world, most days are just awful, and tomorrow probably isn't going to be any better. But new clothes might make one feel temporarily renewed.

Fashionistas, with their obsession about what's new and what's next, are the ultimate expression of hoping that tomorrow will be better or at least just different. This outlook gives them an aptitude for picking up and moving on. There's nothing more pathetic than older celebrities clinging to the clothes and makeup of their prime years, as if wearing the look from the period they were loved will make it come back.

Tax practitioners aren't good at moving on. Once they've perfected a tax plan, they are reluctant to let go, even after a court has bounced it, regulations have dented it, or Congress has repealed it. Every technical tax plan has its day. No tax gimmick works forever. Move on. Some people, like Broadway Joe Namath, haven't moved on (fashionistas will notice that we're continuing our coyote theme).

There is not much debate anymore that the OECD's base erosion and profit-shifting project is about getting U.S. multinationals to pay some tax to European market countries. Even if that premise were debatable, it is not debatable in the case of hybrids. U.S. multinationals have some hybrid capabilities -- bestowed by U.S. law -- that their European counterparts do not have.

Hybrids are a clear case of U.S. companies stripping other countries' tax bases. There's no right of multinationals to strip income out of other countries, even in the indulgent international consensus. There's no defense their home government can present. If the United States wants to continue to use the OECD as a vehicle for its needs, it can't be too defensive about the hybrid antics that U.S. administrative rules permit.

This article describes what we know about the leaked BEPS hybrid draft, which would implement action 2 of the BEPS action plan and follows up on the OECD's 2012 hybrid report with proposed solutions. That report concluded that the specific hybrid mismatch rules already adopted by several European countries are effective. (See OECD, "Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues" (Mar. 5, 2012).)

The leaked hybrid draft, which dates from last October, describes what is essentially a set of subject-to-tax rules with gateways for financing for a certain kind of hybrid and ordering rules for which rule to apply. The draft approach would move the debate to whether the arrangement was within the gateway.

The ball does not appear to have moved on this subject since last October. A public consultation draft is scheduled to be released in March.


Hybrid arbitrage is the crown jewel of U.S. international tax planning. It is enabled by the creation of hybrid financial flows and by the check-the-box rules (reg. section 301.7701-3). The check-the-box rules are so entrenched that legislative repeal might be required, meaning the U.S. delegation could blame Congress for any failure to accede to BEPS demands. The Obama administration did not call for repeal in its most recent budget.

European countries figured it out early, but didn't get any effective rules in place for nearly two decades. They did complain to the United States soon after the check-the-box rules were adopted.

Notice 98-11, 1998-1 C.B. 433, treating disregarded entities as corporations for subpart F purposes, was partially informed by other countries griping. Treasury was trying to salvage the subpart F rules and the U.S. tax base while trying to be a good world citizen at the same time. But, prodded by angry multinationals and their advisers, Congress took the position then that arbitrage is acceptable because it only hurts other countries, and not the U.S. fisc. Notice 98-11 was reversed, for a minimum of five years, that has since become 15 (Notice 98-35, 1998-2 C.B. 34).

Broadway Joe Namath hasn't moved on from his '70s look. Did no one think that the Europeans would eventually catch on and move to disallow check-the-box results? (JOHN ANGELILLO/UPI/Newscom)Did no one think that one day, Europeans would catch on and do something to disallow check-the-box results? Several European countries have already acted. Other European multilateral institutions have been recommending specific changes to address U.S. multinationals' hybrid arbitrage for more than a year now.

The European Commission recently proposed an amendment to the EU parent-subsidiary directive (2011/96/EU), which excuses dividends from taxation when paid to a parent company. The proposed amendment would deny exemption when the payer deducted the payment in a hybrid loan context. EU governments would also be asked to devise a common general antiabuse rule (COM (2013) 814).

Previously, the European Union Code of Conduct Group (Business Taxation) told the Economic and Financial Affairs Council that a participation exemption should be denied when dividends had been deducted by the payer (Council Doc. 1766/10). That group is working on recommendations for EU rules on deduction disallowance that would not be limited to related-party transactions. That work is continuing.

There is not much that the OECD would be telling European governments to do that they haven't been told to do already, and that Germany hasn't already done. But the OECD imprimatur provides political cover for governments that otherwise would be afraid of offending multinationals. The endorsement of any multilateral body might be useful when a European government had to defend a case in the European Court of Justice.

What bothers the U.S. delegation is the scope of transactions covered, and the possibility that the Europeans might get their act together and act consistently. If most European market countries had harmonious rules, the opportunities for arbitrage would be lessened, and U.S. tax planners might not be able to pick them off quite so easily. The leaked hybrid draft asks that European governments adopt parallel and consistent rules, using a common model and neutral language, adjusted to their particular situations.

Resolving the arbitrage questions raised by hybrid payments, entities, and transfers is easier said than done. The complexity comes from attempts to narrow the range of transactions covered, and the need to analyze the other country's treatment. Resolution often requires information about how the other country is treating the transaction or entity (some countries ask for certification from the other tax authority).

But on the whole, the international rules need to pay attention to what happens in the other country. That should become a best practice. The hybrid draft encourages inquiry into the other country's treatment. In the future, multinationals will not be able to count on the ability to tell different stories to different governments.

Hybrid Payments

The BEPS draft contemplates a hybrid payment rule that would deny a participation exemption when the payment has been deducted by the payer in a financing/funding transaction. A secondary rule would deny a deduction when the payment is taxable to the recipient. This proposal matches the commission's proposed parent-subsidiary directive amendment.

The rule would only apply to payments and things considered payments in law, like accruals in accrual-based accounting. It would not apply to cockamamie schemes like the Belgian and Luxembourgian notional interest deductions.

Germany already has a similar rule that does not require a financing transaction. German domestic law denies exemption when a German resident's foreign income is not effectively taxed in the partner country (section 8 of the German Law on External Tax Relations (Aussensteuergesetz)). Austria and Italy have similar rules.

Even if OECD Working Party 11 stalls on hybrids, European governments would still have German rules as a model. They are already using German interest barrier rules as a model to restrain income stripping via interest deductions.

The working group seems to want the disallowed deduction or forced inclusion to be proportionate to the non-inclusion or deduction on the other side. In this, they may have been inspired by the work of Sven-Olof Lodin of Stockholm University. Lodin would replace interest and royalty deductions with an inverted tax credit for foreign taxes to achieve precision in removing the benefit of deductible payments that are not taxed to the payee (Tax Notes Int'l, Sept. 30, 2013, p. 1317; and Tax Notes Int'l, July 18, 2011, p. 177).

A BEPS hybrid rule would be intended to act automatically whenever a payment came across the border having been deducted at the paying end. No questions asked. No tax avoidance motive required. At least the working party understood that the intent and effect tests of British hybrid rules make them weaker. (Prior discussion: Tax Notes, Apr. 4, 2005, p. 15.)

The proposed hybrid rule would not recharacterize payments. In European systems, there is very little statutory recharacterization and no tradition of judicial recharacterization. The EU parent-subsidiary directive might also be a blockade to recharacterization. The commission seems to believe that recharacterization violates the directive.

The BEPS action plan says that a hybrid mismatch rule should not apply to deny a deduction when a controlled foreign corporation rule already applies at the receiving end. But the proposed rule would not excuse the payment if a CFC rule picked it up and taxed it to the payee's parent. Theoretically, there should be an exemption (Tax Notes, Apr. 1, 2013, p. 25). But that would require not merely third-country information, but also effective CFC rules, which Europe can no longer maintain (Cadbury Schweppes, C-196/04).

Payer and payee are usually related in hybrid structures. But the model hybrid rule would apply when payer and payee are unrelated. The United States strenuously opposes this aspect. This is the only part of the draft that the U.S. side can legitimately object to.

Some consideration is being given to making an exception when a hybrid debt security is publicly traded -- in which case the payer would have a deduction and the payee is likely to be effectively tax exempt. The BEPS proposal would not seem to apply to ordinary convertible debt.

Disregarded Entity

European multinationals can construct hybrid entities the old-fashioned way, and their low effective tax rates show that they must be doing some planning. But they can't make entities disappear. Only Italy has check-the-box rules, but this election is not available to single-member entities (article 114 of the Income Tax Code).

So when the U.S. side says the Europeans are being hypocrites, it is true only up to the point that U.S. companies can pull a powerful disappearing act that prevents stripped income from being taxed at home.

In the bog-standard U.S. income-stripping practice, a foreign entity that is disregarded by the United States, but is a taxable corporation in its country of residence, makes an interest payment to its U.S. parent. It deducts the interest against its corporate income in its home country. The U.S. tax system does not see that payment -- which does have to be explained in financial accounts, because it is an actual payment.

What should the hybrid's country of residence do, assuming that the United States would do nothing? The working party might be better off assuming that the United States will not act.

This transaction would seem to fall under the secondary rule discussed above, and the hybrid's country should deny a deduction because the United States does not plan on forcing inclusion. But the BEPS working party appears to be offended only when the interest deduction is used to offset local income that is not taxable in the United States -- that is, shared in a combined filing by the hybrid and a local affiliate.

Double Deduction

Another model hybrid rule would address double deductions. The check-the-box rules are essential to double deductions. The 2012 hybrid report discussed a case in which the hybrid entity makes an interest payment to a same-country lender that is deductible in its country of residence. The interest payment may also be deductible in the United States, where the entity could be considered a branch.

If the entity is not sharing the loss represented by the interest deduction, the 2012 OECD hybrid states that there is no problem. The United States taxes on a worldwide basis, and the entity's country of residence is presumably territorial, so two interest deductions are merely a function of overlapping taxation of the same income of the entity/branch.

But if the disregarded entity joins in a combined return with a same-country affiliate, against whose income the deduction is used, that country would be suffering an unwarranted deduction, because the affiliate's income would not be taxable in the United States. The hybrid may be an acquisition vehicle, and the income-producing affiliate may be a target company.

How should the entity's country of residence respond? Should it disallow combined filing for the entity/branch? The entity would have to tell its home government that it is treated as disregarded in the United States and that its parent is also deducting the interest.

The BEPS working party wants to deny a deduction when the parent has nonrecognition. Again, the working party is reluctant to recharacterize the disregarded entity, even though recognizing it as a corporation would facilitate addressing transactions to which it is a party.

Denmark would treat the entity the same way it is treated in its country of residence (section 2A of the Danish Corporate Tax Act). That is, treating the entity as transparent has the effect of nullifying the deduction.

The United States has dual consolidated loss (DCL) rules but permits disregarded entities to be used to avoid them (section 1503(d)). If a foreign tax nothing borrows from its U.S. parent and incurs loss-making interest expense, the U.S. system does not recognize the existence of either the entity or the interest expense, so the latter would not be counted in calculating a DCL. But if the foreign jurisdiction recognized the existence of the entity as a corporation, and its income was not taxed currently by the United States, the interest expense would be part of a DCL. (Prior coverage: Tax Notes, May 18, 2009, p. 803.)

The United Kingdom has a complicated rule that requires a substantial tax advantage to a British company (section 244 of the Taxation (International and Other Provisions) Act 2010). Germany has dual loss prohibitions (section 14.1.5 of the Corporation Tax Act 2010).

Alternatively, the U.S. parent should be denied an interest deduction, but the United States won't do that. Foreign-parented companies operating in the United States strip income out via interest deductions on a wholesale basis, and no one lifts a finger to stop them. They hire U.S. nationals in Southern states when U.S. companies barely hire domestically, and they have an effective lobby in Washington.


Cross-border repos that produce interest deductions in the United States (where they are treated as loans) and non-inclusion in the other country (which sees a dividend following a sale of shares) are still possible when the other country is not the United Kingdom. Cross-border sale-leasebacks are also possible because the country where the sale is booked may not treat the transaction as a loan.

When the British put the kibosh on these gimmicks, practitioners understood that their time was limited but carried on doing them with countries that hadn't bothered to change their laws (Tax Notes, Sept. 9, 2013, p. 1055). The Europeans evidently don't want to recharacterize these transactions, but they should. European law is in trouble because it is so reliant on form, and the old cliché about omelets and eggs is pertinent.

In the situation posited in the 2012 OECD hybrid report, a U.S. parent owns the two foreign subsidiaries in the same country. The first subsidiary owns the second subsidiary. The parent makes a deferred purchase of shares of the second subsidiary from the first subsidiary. The first subsidiary agreed to buy the shares back at a later date, making the deal a repo.

The second subsidiary pays dividends to the first subsidiary, which is still its parent. These dividends are exempt under local law, which treats the deal as a deferred sale. The United States treats the transaction as a loan by the first subsidiary to the parent, secured by the shares of the second subsidiary. The parent is taxable on the dividends, which it washes out with interest deductions and an indirect foreign tax credit for the second subsidiary's local income tax. Both parties are treated as the tax owners of the shares in their respective countries.

Thus the dividends received by the first subsidiary are not only exempt, but have effectively been converted to deductible interest. It's incredible that no one seems to have asked why a group needs to do a repo over shares of an affiliate. Intragroup transactions involving shares of a member should automatically be suspect. The United States does not object to these transactions unless they are foreign tax credit generators (reg. section 1.901-2(e)(5)(iv)).

The sale-leaseback version is essentially the same transaction, but with business assets instead of subsidiary shares. The foreign parent sells the assets to its U.S. subsidiary and then leases them back. The United States treats the sale-leaseback as a loan by the subsidiary to the parent, secured by the assets. The parent's deductible rent may be treated as receipt of loan principal by the subsidiary. Neither party is treated as the tax owner of the assets.

As in the hybrid finance situation, the BEPS working group seems to want to first deny the interest or rent deduction, and second, force inclusion of the payments in the subsidiary's income. It would basically be a subject-to-tax rule for repos and sale-leasebacks.

Gee, why not just treat these deals as financings, the way the rosbifs do? It is in the interest of all countries that laws be changed to treat repos and sale-leasebacks as loans because these transactions are commonly used for financial purposes and should not be disguised as something other than the loans they represent.

There appears to be reluctance on the part of the BEPS working group to mess with traditional tax and corporate law characterizations of transactions. The idea appears to be to attack the undesirable tax result and not meddle further. The reluctance to recharacterize these transfers, or any of the payments or entities discussed previously, weakens the rules. Attacking the symptoms rather than the problem is not a good long-run approach.

The Clinton Treasury -- yes, the folks who gave us check-the-box -- found that out the hard way in 1995, when it presented a series of proposals seeking to deny interest deductions on exotic securities without recharacterizing them as something other than debt. Wall Street dubbed the proposals "Pearl Harbor Day" and beat them back. (Prior coverage: Tax Notes, Dec. 18, 1995, p. 1437.) So default to debt treatment was cemented in the law, and taxpayers could have interest deductions on any security and in any amount they chose.

About Tax Analysts

Tax Analysts is an influential provider of tax news and analysis for the global community. Over 150,000 tax professionals in law and accounting firms, corporations, and government agencies rely on Tax Analysts' federal, state, and international content daily. Key products include Tax Notes, Tax Notes Today, State Tax Notes, State Tax Today, Tax Notes International, and Worldwide Tax Daily. Founded in 1970 as a nonprofit organization, Tax Analysts has the industry's largest tax-dedicated correspondent staff, with more than 250 domestic and international correspondents. For more information, visit our home page.

For reprint permission or other information, contact