Hybrid mismatch rules explained

23 January 2018

A hybrid mismatch occurs in circumstances where the tax treatment of financial instruments, entities or transfer arrangements varies between territories.

The hybrid rules, which came into force on 1 January 2017 in response to Action 2 of the OECD Base Erosion and Profit Shifting (BEPS) project, aim to prevent tax mismatches where the same item of expenditure is deductible in more than one jurisdiction, or where expenditure is tax deductible but the corresponding income is not fully taxable (or the income is taxed at a beneficial rate or is deferred to a future period).

A simple example of mismatch caused by a ‘hybrid’ instrument is where a borrower pays a (tax-deductible) coupon on an instrument which the recipient, in a different jurisdiction, characterises as a return on (tax-exempt) equity.

These rules require an understanding of how a payment either made or received by the counterparty, under a qualifying arrangement, would be treated for tax purposes in a foreign jurisdiction. This also assumes that the parties in an arrangement would be able and willing to readily share tax information, which is clearly not always the case.

Once determined, the operative effect of the rules is relatively simple; to the extent there is a mismatch, either a deduction is disallowed or an amount is included in assessable income.

Although the rules implementing the above are complex, in broad terms they may be summarised as applying to payments under schemes involving hybridity of financial instruments or entities, and occurring in the context of related party and/or structured arrangements. Notably, the rules could potentially apply to all kinds of payments (including royalties, rent, interest and service payments).

What action should be taken?

Groups should assess their cross border transactions and current arrangements.  If there are arrangements which may be caught under the hybrid mismatch rules, it will be necessary to consider whether it is appropriate to restructure in order to eliminate the hybrid elements.

If you have any questions about this blog, please contact me or your usual UHY adviser or fill out our contact form here.