To control “hybrids” we just have to be “amphibians” (Part II)

Tax effects of hybrid arrangements

In order to facilitate the understanding of the problem that is addressed in the Action 2 of the BEPS Action Plan, treated in my previous post, we are going to provide some examples.

The existence of a disagreement between two countries over who or what constitutes a person can lead to disagreements about who owns an asset or who receives a payment with respect to the use of an asset. On the other hand, disagreements over the relationship between two persons would lead to disagreements about the value to which a transaction should be quantified and the characterization of the respective payment.

For example, subject a, resident in Country A, makes a payment which is deductible for tax purposes. Country A believes that this payment is made to b, resident in country B. Country B, in turn, considers that the payment is made to c, resident in the country A. Faced with this situation, there is a tax deduction by a, which does not generates tax income, nor in countries A and nor in B.

When processing a payment, many other cases can occur. If a country recognizes a payment, but can’t agree on who should be considered the paying agent (this situation generates double deduction). When two countries recognize a payment, but do not agree on the amount of the payment (this situation generates a deduction higher than the generated income tax). When the payment is recognized, but there is no agreement about the moment in which the payment should be recognized for tax purposes or when a payment is recognized, but there is no agreement on its characterization for tax purposes.

The following example relates to imbalances generated by activities creating resources and income. Country A characterized the activity of a as an investment while country B considers it as a business. The result is that country A does not tax the investment and country B does not tax the business, because of a rule that grants tax benefits. This case produced a double non-taxation as a result.

Also mismatches can be generated in operations involving brokers. Subject b, resident in country B, sells goods to country A through an agreement with a broker. Under this agreement, broker a, residing in country A, alienates the products of b to a third party, in name of a, but on behalf of b. Country A believes that b is not related by contract to third parties and then does not consider the activity associated with that contract. As a result, country A does not consider b as a permanent establishment. Therefore, it does not tax b, but taxes the broker a, for the commissions on the sales. On the contrary, country B considers that b leads the business in the country A through the broker (a) and considers that b has a permanent establishment in the country A. As a result, country B guarantees to taxpayer b a tax benefit in the form of an exemption on the utilities that his sales have generated.

Additionally, there are cases of mismatches in criteria to establish ownership of an asset, generating double deduction in respect of depreciation and imbalances in the characterization of assets, creating this double deduction in tax benefits for dividends.

The following example shows a case where imbalances are generated as a result of a different understanding between two countries on what or who constitutes a person for tax purposes. Two countries may not be in agreement whether an entity constitutes a person for tax purposes (hybrid entity), and this can generate mismatches in relation to the interpretation of two tax administrations on the effective delivery of a payment. Subject b, resident in country B, establishes the company a, in country A. “b” grants a loan to “a”, who pays interests on the loan. Country A believes that “a” is a taxable person and allows a deduction for the interest paid. Country B considers that “a” is a transparent (not taxed) entity and therefore does not recognize the loan transaction and its consequent interest payment. Country B considers the activity of “a” as a permanent establishment of b in Country A. As a result, it grants to “b” a tax benefit in the form of exemption for their activity in country A.

Other cases with similar effect are caused by mismatches regarding residence, generating either a deduction without a consistent taxation in the country of residence, either a double deduction.

As we have seen, part of the complexity of hybrids is that they usually involve countries which, by their nature, are not the typical tax havens. If they involve countries that are part of tax treaties, this leads to the need to review the fact that the fundamental purpose of a tax treaty should be avoiding the double international taxation and not preventing the international double no-taxation.

In this issue of hybrids, it is difficult to think of a unique solution that all countries should take. For this purpose, it is important to consider the administrative capacity and context of each of them. For this reason, it is very relevant to continue dedicating efforts to identify solutions increasingly more holistic, which are managed by countries and which in turn does not significantly increase the taxpayers’ compliance costs.

The challenge is great. The control of “hybrids” requires numerous policy changes and sufficient administrative capacity to investigate. For example, the conditions of a financial instrument or entity, to assess the tax treatment that is given under the tax standard from another country and to investigate the relationship of each party involved with respect to each payment, analyzing the reasons that originated it. The coordination between countries is therefore key to harmonize the solutions – here emphasize the role of OECD and of the international organizations that support BEPS. To do so require a change in the culture and the way of working in many countries – especially those that adopted a criterion of territorial income-, which often disregard or don’t seek to understand the tax rules in other countries, or the way they act.

In this field, there are international experiences which deserve to be observed, such as the 2016 / 1164 Anti-Avoidance Directive of the EU Council, 12 July 2016, which was a compendium of measures seeking to ensure taxation at the place where the value and benefits are generated, including some of the recommendations of the BEPS Action Plan, including those referring to hybrids. For their part, Spain (2014), Germany (2012 and 2014), France (2013-2015), Italy, United Kingdom (2017), Mexico (2014), Japan (2015) and Australia (2014) have implemented several measures between the years 2012 and today. Some of these countries are currently assessing regulatory changes to adopt the BEPS recommendations.

As it is usual, the global taxpayers are always several steps ahead of the tax administration, with sophisticated networks that allow designing strategies that best fit their interests. The countries have made much progress in international coordination, but apart from the BEPS project, we are still unable to perceive a widespread motivation for understanding what’s occurring abroad and the underlying reasons. Without this ability, it would be impossible to find the best solutions. Here, math and biology can help us. From a mathematical viewpoint, taxpayers carry out the “derivatives” while the administrations must calculate the “integers” to know what exactly the taxpayer did. From the biological’s viewpoint, I come back to the title of this post “to control hybrid we have to be amphibians”: as well as amphibians, a country must have a capacity of transformation during the period of development, through a metamorphosis, to increase its action capacity and be able to move through different fields, beyond its borders.

Consulted texts:

United Nations handbook on Selected Issues in Protecting the Tax base of Developing Countries. 2015.

Project OECD/G20 on the tax base erosion and profits shifting. Final Reports 2015. Abstracts.

Action 2: neutralize the effects of hybrid arrangements. Tax and competitiveness Foundation. 2017.

BEPS.

Principales implicados para el sector financiero. Ernst & Young. 2015.

Disclaimer. Readers are informed that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group the author might be associated with, nor to the Executive Secretariat of CIAT. The author is also responsible for the precision and accuracy of data and sources.

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