Can OECD initiatives eliminate or mitigate hybrid ...

Can OECD initiatives eliminate or mitigate hybrid financial instruments tax effects? And what

can be proposed as alternative solution?

Ekaterina Pleskova

student number: 1259865

ARN: 290917

Supervisor: Mr.dr. D.S. Daniel Smit

Academic year 2013/2014

LLM International Business Tax Law 2013/2014 – track: International Business Tax Law

2

List of Abbreviations

Art Article

BEPS Base Erosion and Profit Shifting

CFC Controlled foreign company (corporation)

CIT Corporate Income Tax

ECJ European Court of Justice

EU European Union

GAAR General Anti-Abuse Rules

GAAP Generally accepted accounting principles

OECD Organisation for Economic Co-operation and Development

The Report OECD OECD Report “Hybrid Mismatch Arrangements, Tax Policy and Compliance

Issues”

The Draft Public Discussion Draft “Neutralise the effects of Hybrid Mismatch Arrangements –

Recommendations for Domestic Laws”

P Page

RPS Redeemable preference shares

Sec. Section

Vol. Volume

WHT Withholding Tax

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Table of Contents

List of Abbreviations ........................................................................................................................................... 2 Abstract .............................................................................................................................................................. 4 Introduction ........................................................................................................................................................ 4 Chapter 1. Hybrid financial instruments and qualification conflict ..................................................................... 6

1.1. Hybrid financial instruments. General issues .......................................................................................... 6 1.1.1. Distinction of debt and equity and their features .............................................................................. 6 1.1.2. Hybrid financial instruments and qualification conflict ...................................................................... 8 1.1.3. Why Hybrid financial Instruments are used? .................................................................................... 8

1.2. Hybrid financial instruments and their treatment under civil law and accounting rules .......................... 9 1.2.1 Summary of civil law treatment of hybrid financial instruments ........................................................ 9 1.2.2. Accounting rules and reclassification in practice ............................................................................ 10 1.2.3. Economic view on hybrid financial instruments ............................................................................... 11

1.3. Tax consequences of hybrid financial instruments schemes ................................................................ 12 1.3.1. Tax effect on inbound and outbound finance ................................................................................. 12 1.3.2. Hybrid instruments and tax arbitrage ............................................................................................. 13

1.4. Short summary of the Chapter .............................................................................................................. 13 Chapter 2. Initiatives proposed by OECD ........................................................................................................ 15

2.1. OECD Report “Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues” ......................... 15 2.2. BEPS. Action 2. Neutralize the Effects of Hybrid Mismatch Arrangement ............................................ 16 2.3. The Public Discussion Drafts were released, BEPS Action 2: Neutralize the Effects of Hybrid Mismatch Arrangements (Treaty Issues) ..................................................................................................... 17

2.3.1. Scope of the Draft and underlined principles ................................................................................. 17 2.3.2. The proposed rule .......................................................................................................................... 18 2.3.3. Definitions of payments and effect of the designed rule ................................................................ 20 2.3.4. The scope of the designed rule. Bottom-up and top-down approaches ........................................ 20 2.3.4.1. Bottom-up approach .................................................................................................................... 21

2.4. Brief summary of the Chapter ............................................................................................................... 22 Chapter 3. Analysis of proposed measures ..................................................................................................... 24

3.1 Principles applicable to the cross-boarder transactions ........................................................................ 24 3.1.1 Source and residence taxation ........................................................................................................ 24 3.1.2 Principle of origin ............................................................................................................................. 25 3.1.3. Economical principles ..................................................................................................................... 27

3.2. Analysis of ”Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues” .............................. 28 3.3. BEPS.Action 2. Neutralize the Effects of Hybrid Mismatch Arrangement ............................................ 29 3.3. The Draft ............................................................................................................................................... 31

3.3.1 General positions ............................................................................................................................ 31 3.3.2. Proposed rules ............................................................................................................................... 32 3.3.3. “Top-Down” vs. “Bottom-Up” ........................................................................................................... 33 3.3.4. Allocation of taxing right ................................................................................................................. 34 3.3.5. Other issues ................................................................................................................................... 34

3.4. Brief summary of the Chapter ............................................................................................................... 35 Chapter 4. Alternative solutions ....................................................................................................................... 37

4.1. Countries experience in tackling hybrid practice .................................................................................. 37 4.2. Alternatives outlined by the scholars ..................................................................................................... 38 4.3. Interrelation of harmonized rule with company law and accounting ..................................................... 39 4.4. Alternative solution – harmonized tax classification .............................................................................. 40

4.4.1. Criteria for a rule. ............................................................................................................................ 40 4.4.2. Allocation of taxing rights – residence/source/ origin ..................................................................... 41 4.4.3. The scope – to what transactions harmonized rule should be applied .......................................... 42

4.5. Area for development of alternative solutions ....................................................................................... 43 4.6. Short summary of the Chapter 4 ........................................................................................................... 43

Conclusion ....................................................................................................................................................... 45 Bibliography ..................................................................................................................................................... 48

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Abstract

This Master Thesis analyzes the OECD initiatives addressed tax consequences of hybrid financial

instruments which result in double taxation and double non-taxation in cross-boarder transactions. Such

benefits of hybrid financial instruments are explained by different treatment in two jurisdictions, debt in one

country and equity in another. This different treatment is known as qualification conflict. These hybrid

financial instruments artificially reduce the tax base in part of debt financing in one jurisdiction and employs

exemptions for equity finance in another jurisdiction.

Specifically, the OECD, Hybrid Mismatch Arrangements, Tax Policy and Compliance Issues and OECD,

“Base erosion and profit shifting”, Action 2 “Neutralize the Effects of Hybrid Mismatch Arrangement”

provides policies and main measures to eliminate hybrid mismatches tax effect. In the framework of BEPS

plan, the Public Discussion Draft “Neutralize the effects of Hybrid Mismatch Arrangements –

Recommendations for Domestic Laws” was published where a draft of a rule was designed. This rule

includes some changes in withholding taxation and linking rule for corporate tax treatment of hybrid

financial instruments. However, the draft of rule needs some improvement and it is not clear whether its

application will be effective and eliminate negative tax consequences of hybrid financial instruments. As

alternative solution regulation of qualification conflict will be proposed. This alternative will be based on

determination of whether it is purely debt or purely equity finance.

Introduction

Nowadays, more and more companies are involved in cross-boarder transactions. The one of the mechanisms

to obtain tax advantages from such transactions is the usage of hybrid financial instruments. In last years,

market of financial instruments has grown and developed the new types of hybrid financial instruments. The

main feature of all instruments can be determined as combination of debt and equity, i.e. their remuneration

is classified as both interest and dividends and, thus, is treated differently in both countries1. The mismatch

results in double taxation or double non-taxation. Both results are negative from a taxpayer and country

perspectives. Some countries introduced rules dealing with hybrid financial instruments. However, these

instruments are mostly used in cross-boarder context and regulation on international level is required.

International society, in particular the Organization for Economic Co-operation and Development (OECD),

is interested in elimination and regulation of this mismatch raised by the hybrid financial instruments. Within

the OECD several initiatives were developed. In particular, OECD report “Addressing Base Erosion and

Profit Shifting” (BEPS) develops these ideas and, as neutralization of hybrid mismatch arrangements effect,

include the following2:

changes to the OECD Model Tax Convention to ensure that hybrid instruments are not used to

obtain the benefits of treaties unduly;

1 Sven-Eric Barsch, Christoph Spengel, “Hybrid Mismatch Arrangements: OECD Recommendations and German

Practice“, Bulletin for international taxation, October 2013

2 OECD, “Base erosion and profit shifting”, Action 2 “Neutralize the Effects of Hybrid Mismatch Arrangement”, 12

February 2013

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domestic law provisions that prevent exemption or non-recognition for payments that are

deductible by the payer;

domestic law provisions that deny a deduction for a payment that is not included in income by

the recipient (and is not subject to taxation under controlled foreign company (CFC) or similar

rules);

domestic law provisions that deny a deduction for a payment that is also deductible in another

jurisdiction; and

where necessary, guidance on co-ordination or tie-breaker rules if more than one country seeks

to apply such rules to a transaction or structure.

On the basis of BEPS two recommendations were adopted: Public discussion draft “Neutralize the effects of

Hybrid Mismatch Arrangements – Recommendations for Domestic Laws” (the Draft) and Public discussion

draft “Neutralize the effects of Hybrid Mismatch Arrangements –Treaty Aspects of the Work on Action 2 of

the BEPS Action Plan” (the Draft regarding Treaty aspects). The Draft proposes a hybrid mismatches rule.

The goal of the research is to identify whether the above mentioned OECD initiatives tackle abusive tax

planning involving hybrid financial instruments.

The research question is

Can OECD initiatives eliminate or mitigate hybrid financial instruments tax effects? And what can be

proposed as alternative solution?

Нybrid financial instruments schemes are run by various reasons, including tax benefits, financial

circumstances, company's financial health, etc. Also commercial, regulatory and accounting grounds

influence on decision to implement hybrid financial instruments schemes. Such schemes are advantageous as

flexible for both investors and receiver3. In addition, the tax issues arise due to different treatment of debt

and equity.

Taking this into account, I believe that it is essential to analyze hybrid financial instruments from the legal

and accounting points of view as well. Such analysis allows understanding grounds of different treatment of

debt and equity and, hence, shows the ways for the problem elimination (if it is possible). This analysis will

be performed in the framework of chapter 1. I will analyze main distinctive features of debt and equity,

reasons and types of qualification conflict. I will also look at the problem from civil law and accounting

points of view. This chapter will indicate tax problems raised by hybrid financial instruments usage in tax

planning and why international taxation is in need to solve it. Identification of the problem, its reasons and

consequences allow analyzing potential solution.

In chapter 2 I will analyze measures proposed by OECD. I will limit my analysis to classic financial

instrument indicated in the Draft4. I will not analyze thin capitalization rules, and details of hybrid financial

instruments regulations in other countries.

3 Bulletin for International Taxation, «Brazil/United Kingdom/United States. Cross-Border Intra-Group Hybrid Finance: A Comparative Analysis of the Legal Approach Adopted by Brazil, the United Kingdom and the United

States», Rafael Minervino Bispo, June 2013, No. 7

4 Public Discussion Draft “Neutralize the effects of Hybrid Mismatch Arrangements – Recommendations for Domestic

Laws”, p.61

6

Then, in the chapter 3 I will examine whether proposed measure can mitigate or eliminate hybrid financial

effect. In particular, I will analyze whether the measure are advantageous for investor and investment's

receiver, could they be adopted. In the framework of my research I will analyze the measures for their

sufficiency and attainability. In addition, as hybrid financial instruments are used in cross-boarder

transactions I would like to estimate proposed measures and a rule whether they are in compliance with tax

neutrality principles and standards established by the Draft. I also analyze international allocation of taxing

rights according to the designed rule.

As hybrid financial instruments are used in cross-boarder arrangements in order to benefit from different

regulations, I believe that analysis of taxing rights allocation, compliance with tax neutrality principle are

good benchmark for valuation of the OECD initiatives. Moreover, any cross-boarder rules should not impede

economic development, distort competition and put unfair and additional burden on business.

Impact of hybrid financial instruments is complex. On the one hand, hybrid financial instruments “serve to

raising capital in a cost efficient manner, accommodating to the investors demands, hedging risks, uprising

capital flows and investment opportunities“5.

On the other hand, hybrid financial instruments lead to double taxation and double non-taxation. Thus,

hybrid financial instruments are often use by tax planners to reduce tax burden in the group of companies.

These factors indicate that dealing with this problem should take into account all aspects, legal and

accounting as well.

At the same time, the measures proposed in OECD initiatives do not include these factors in tackling abusive

tax planning involving hybrid financial instruments. In last chapter I also will propose alternative solution.

In particular, I will try to develop harmonized rule based on distinctive criteria and evaluate this rule.

Chapter 1. Hybrid financial instruments and qualification conflict

1.1. Hybrid financial instruments. General issues

1.1.1. Distinction of debt and equity and their features

A hybrid financial instrument is an instrument contains characteristics of both debt and equity. The analysis

of hybrid financial instruments should be started with identification of debt and equity distinction.

Typically equity is considered as a “participation in the entrepreneurial risks and rewards of a business”6. It

also reflects an extent of a person’s economic interest in a particular asset. “Debt is typically seen as an

unqualified obligation to pay a sum certain at a fixed maturity date along with a fixed percentage of

interest”7.

Different theories provide for various distinctive features of debt and equity. Thus, Charles P. Normandin

stated that relationships with shareholders are characterized by a fiduciary responsibility and contractual

5 Francisco Alfredo, “Qualification of Hybrid Financial Instruments in Tax Treaties”, Universitat de Valencia

6 Nadine Wiedermann-Ondrej, “Tax Treatment of Revenue Based Payments”, (Vienna University of Economics and

Business Administration - Department of Tax Law, 2007), p. 6

7 Nadine Wiedermann-Ondrej, “Tax Treatment of Revenue Based Payments”, (Vienna University of Economics and


http://online.ibfd.org/linkresolver/static/itg_asset?WT.z_nav=crosslinks

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agreements are connected with creditors8. At the same time, others indicated that both relationships are built

on contractual basis, but they are subject to different contracts9.

Legal uncertainty and different theories aggravate the distinction problems. In addition, there is no unified

definition of neither debt nor equity and each country provides own rules to determine and distinguish these

definitions. At the same time, substance of both notions are different and based on worldwide practice the

main features of debt and characteristics of equity can be identified.

The following debt characteristics can be found:

the remuneration amount is strictly defined10

;

creditors do not have any control over company, which is opposite to shareholders rights11

;

subordination is one of essential factors to distinguish debt from equity12

. For example, in case of

force majeure, the holder of a debt obligation has a right to be paid before any funds become

available to shareholders13

;

one of the other important characteristics of debts is maturity14

, so the fund must be paid out within

the agreed period of time. Depending on the fact whether a debt has a specified term of payment,

countries determine treatment whether it is debt or equity.

The equity can be identified based on the following:

return is linked to earnings. Dividends are paid from certain funds legally available for such

purpose15

;

for debts short term of redemption is characterized;

different timing of realization of payments. Dividends are realized as income at the moment of

payment and declaration. With respect to loans payments different rules are provided, for example,

payments can be realized not at the moment of being paid but accrued16

.

Summarizing above mentioned, the following decisive criteria can be identified17

: (1) maturity; (2) seniority;

(3) management; and (4) return.

For debts fixed maturity is typical, and debt interests are preferential in comparison to equity remuneration.

At the same time, “creditors are not entitled to voting rights and their return takes the form of a fixed-rate

8 Richard W. Kopcke and Eric S. Rosengren, “Are the Distinctions between Debt and Equity Disappearing?”, 1983, p.

5

9 Ibid

10 Dominik Gajewski, “The Role of Hybrid Instruments in the Implementation of Business Tax Policy”,

Contemporary economics, 21 December 2012, p. 87

11 Ibid

12 J. Duncan, General Report, in Tax Treatment of Hybrid Financial Instruments in Cross-border Transactions, Cahiers

de Droit Fiscal International, vol. 85a, sec. 2. (Kluwer L. Intl. 2000), p. 22-25

13 J. Duncan, General Report, in Tax Treatment of Hybrid Financial Instruments in Cross-border Transactions, Cahiers

de Droit Fiscal International, vol. 85a, sec. 2. (Kluwer L. Intl. 2000), p. 22-25

14

Ibid

15 Ibid

16

Ibid

17

Rafael Minervino Bispo, “Brazil/United Kingdom/United States Cross-Border Intra-Group Hybrid Finance: A

Comparative Analysis of the Legal Approach Adopted by Brazil, the United Kingdom and the United

States”, Bulletin for International Taxation, 2013 (Volume 67), No. 7, 11 June 2013, section 1

8

interest”18

.

The problematic of debt and equity treatment is essential for hybrid financial instruments analysis as it gives

rise to qualification conflict.

1.1.2. Hybrid financial instruments and qualification conflict

A hybrid instrument can be considered as a financial instrument which economic characteristics conflicting

with legal form of instrument. Depending on particular situation the instruments can have different treatment.

In particular, debt can be treated as equity and, conversely, equity is treated as debt. Consequently, they

cannot be conclusively classified as either equity or debt. In practice, potentially hybrid financial instruments

can be considered as corporate shares with features typical debt features and also loans with characteristics

common for equity investments19

. The hybrid financial instruments are often formed by adding certain

elements of equity instruments to debt instruments.

The following types of qualification conflict may be identified20

:

investee’s country treats the instrument as equity for civil law, and as a debt for tax purposes.

Investor’s country classifies the instrument based on investee’s country approach. A good example is

redeemable preference share in Australia, which are treated as equity for civil law and as debt for tax

purposes;

investee’s country the instrument has similar features of debt and equity, in investor’s country

finance resembles equity;

investee’s country applies substance-over-form approach and investor’ s country follows legal form

approach. This is applicable to a zero-coupon loan, where discount is treated by receiving company

as a deductible interest and by financing company as a share investment;

bifurcation approach. Investee’s country splits transaction into two separate, while an investor’s

country respects single transaction approach.

The frequently used hybrid financial instruments are silent partnerships, participating bonds, convertible

bonds, warrant bonds, profit participation loans and preference shares. But more complicated forms of hybrid

finance were used, in particular, forwards and swaps, such as credit default swaps or credit default options21

.

Types of qualification conflicts evidence that the problem is much deeper and more complicated as it may

appear. Moreover, the problems arise not only in tax area, but in legal and accounting treatment as well.

However, hybrid instruments are quite frequently used which is explained by variety of reasons.

1.1.3. Why Hybrid financial Instruments are used?

The reasons of hybrid financing are varied and include such purposes as uprising capital flows, investment

18 Ibid.

19 Nadine Wiedermann-Ondrej, Tax Treatment of Revenue Based Payments, (Vienna University of Economics and


20 Chris Finnery, Paulus Merks, Mario Petriccione, Raffaele Russo; Fundamentals of International tax planning, IBFD.

2007, p. 124- 131

21 F.A. Garcia Prats, “Qualification of Hybrid Financial Instruments in Tax Treaties”, Universitat de Valиncia, p. 14

9

and tax planning opportunities22

. Many authors indicate that the advantage of hybrid financial instruments is

their flexibility to modify an instrument according to the needs of the investor23

. It is also supported by the

fact that there is a great variety and typology of hybrid instruments24

.

This reasoning has led to tax arbitrage and tax avoidance and to differentiating results for economically

identical instruments. This is the reason why some countries follow the substance over form approach which

analyzes the instrument on the basis of its economic characteristics.

All above mentioned indicates that hybrids financial instrument is a notion used not only in tax area but also

in the financial sphere. Such instruments are frequently used by the companies for different reasons,

including tax purposes as well. In spite of different nature of debt and equity and the fact that main

distinctive features identified, hybrid instruments give possibility to convert or differently treat debt and

equity. Qualification conflict allows wide opportunities in tax planning and provides with tax benefits.

Noteworthy, that conflict is raised not only in tax law, but in other disciplines as well. Below, I would like to

briefly describe interrelation with other disciplines, in particular, civil law and accounting.

1.2. Hybrid financial instruments and their treatment under civil law and accounting rules

1.2.1 Summary of civil law treatment of hybrid financial instruments

Generally, tax classification of hybrid instruments is influenced by civil law classification which is a good

starting point for the tax purposes. Mainly, legally treated shares are considered to be dividends-generating

equity in the tax law25

. Some countries, such as Germany and Italy, also follow classification approached

applied in foreign country if share are issued under foreign law26

. At the same time, established by civil law

characteristics are very strict and, generally, do not cover possible variations. Regulated by the civil law

shares resembles more ideal equity27

. Debt features under the civil law are even more flexible in spite of civil

law treatment being starting point for tax purpose classification. Some authors indicate that there is a high

possibility of debt claims classification into both equity and debt for tax purposes28

.

There is no strict guideline for reclassification of debt into equity, which is led to the courts judgment

whether debt or equity finance took place. In practice, courts take into account general features of both.

As an example of possible reclassification, I would like to briefly describe Dutch court case, Caspian Sea

case29

. In this case the Dutch Supreme Court reviewed main features of debt and how legal classification

influence tax treatment. The court held that the essential characteristic of a loan is the repayment obligation

of the debtor. This means that if the recipient of a certain financing is not obliged to repay the amount, the

22 F.A. Garcia Prats, “Qualification of Hybrid Financial Instruments in Tax Treaties”, Universitat de Valencia, p. 14

23 Ibid

24 Ibid

25 Sven-Eric Barsch, “Taxation of Hybrid Financial Instruments and the Remuneration derived therefrom in an

International and cross-border context (Issues and Options for reform)”, Springer, 2012, p. 227

26 Ibid

27 Ibid

28 Ibid

29 �

NL: SC, 8 Sept. 2006, BNB 2007/104

10

financing is, in principle, not considered as a loan. The court also pointed out three exemptions under which

debt for civil law purposes is treated as equity. The exemptions are the following: sham loans

(schijnleningen), loss financing loans (bodemlozeputleningen) and participating loans

(deelnemerschapsleningen). The reclassification takes place if the following requirements are met:

the remuneration on the loan is dependent on the profit of the borrower;

the loan is subordinated to the claims of all other creditors; and

the loan has no term or is perpetual (a loan having a term in excess of 50 years is considered to have

met this condition).

Such reclassification in Dutch tax system is not exception and is possible in other tax systems as well.

Thus, it is apparent that qualification conflict raised in taxation cannot be solved through civil law

application only. Civil law provides general, broad rules. Moreover, hybrid financial instruments are used in

cross-border transactions, and countries’ civil law systems are unique and could treat the same transaction

and financial system differently, harmonization of legal systems is hardly to be reached.

1.2.2. Accounting rules and reclassification in practice

Noteworthy, that distinction of debt and equity is influenced by accounting rules to a great extent as well. As

some authors indicated, accounting rules are aimed at representation of the substance of a transaction,

achieving ideally clarity between a company and investors30

.

However, as I mentioned above the treatment of debt and equity does not have any precise rules or

principles. On the one hand, the starting point for classification is legal treatment. On the other hand, some

countries follow substance-over-form approach and in this case, accounting rules are preferable as being

aimed at fair and true view. At the same time, as no unified approach is adopted with respect to debt and

equity treatment, in practice contradictory decisions are made.

To illustrate this I would like to briefly describe two recent Dutch court cases, issued on 7 February 201431

.

Both cases relate to the qualification for Dutch tax purposes of equity instruments with certain characteristics

of debt. According to the Dutch Supreme Court, the qualification of an equity instrument for tax purposes in

principle follows the corporate law characterization, even if the instrument is considered debt under

accounting rules.

The first case involved Australian redeemable preference shares (RPS) that were issued to shareholder’s

(including Dutch company) by an Australian company. The RPS was characterized by the following:

entitlement to annual and cumulative fixed rate dividends;

priority over other classes of shares for the payment of dividends and repayment of capital;

redemption after 10 years; and

limited voting rights.

In accordance with Australian GAAP, the RPS is treated as a long-term debt. Under Australian corporate tax

rules allow deduction of the dividends for tax purposes. The Dutch company asked for the participation

30 Sasso, Lorenzo, “Capital structure and corporate governance: the role of hybrid financial instruments”, The London

School of Economics and Political Science, 2012, p. 54

31 Dutch Supreme Court 7 February 2014, no. 12/03540 and no. 12/04640

11

exemption on RPS income.

The Supreme Court held that the corporate law qualification is essential for purposes of the Dutch

participation exemption. Classification for corporate law purposes results in tax purposes treatment. This

approach is applicable for RPS regardless of mentioned features and treatment of funds in questions as debt

under Australian and Dutch GAAP .

The second case involved refinance of various banks loans. The Dutch company was initially funded through

loans provided by a syndicate of banks. These loans were “converted” into cumulative preference shares.

Under the contractual terms, the new funding had characteristics of a loan with a fixed period of several

years, at a fixed remuneration. Thus, there was mismatch in treatment of remuneration under these loans as

dividends or interest income.

The Supreme Court’s position is that the corporate law treatment of an instrument is crucial for tax purposes.

According to the Dutch legislation, the preference shares are considered risk bearing capital. The Supreme

Court held that corporate law treatment is applicable to the tax purposes, in particular, the participation

exemption. Under the circumstances of the transaction, there was no significant difference between a capital

contribution and the granting of a loan. But, these arguments are not sufficient to justify reclassification.

Analysis of these cases shows that legal treatment is primary for tax purposes. However, legal qualification

does not consider economic substance of the arrangements.

These cases prove that qualification conflict is much deeper than it may look like. It triggers not only tax but

legal and accounting treatment.

1.2.3. Economic view on hybrid financial instruments

Taking all above mentioned into account, I would like to summarize that tax treatment of hybrid financial

instruments is influenced by civil law characteristics and accounting treatment. At the same time, legal

treatment generally is too formalistic and sometimes cannot solve qualification conflict in specific situations.

Accounting rules, that are a good starting point for tax classification of transactions, also have some

drawbacks. Generally, accounting rules are aimed at fair view presenting and reflecting substance of a deal.

However, I suppose as hybrid finance is a very complicated transaction which generally involves rules and

legislation of countries with different systems, accounting rules do not always prevail in considering hybrid

finance treatment for tax purposes.

Moreover, the tax authorities use tax accounting rules which mainly differ from commercial accounting

rules32

. These differences are also exploited by the companies in hybrid finance schemes.

At the same time, question is very disputable whether economic issues are decisive for tax treatment of

hybrid instruments. On the one hand, economic point of view reflects real meaning of transaction, its

substance. But at the same time, economic reasons are not essential for a company’s decision of financing. In

particular, I would like to briefly describe well-known Modigliani & Miller theorem (M&M theorem), that

includes three proposition supporting that for company’s value there is no distinction between debt and 32 Rafael Minervino Bispo, “Brazil/United Kingdom/United States Cross-Border Intra-Group Hybrid Finance: A



12

equity finance. The first is that company capital structure is independent from type of the investment33

.

The second proposition states interrelation between debt and equity. In particular, not financial structure

could impact on the expected rate of return of a company, but “the grow of the rate of return increases the

amount of debt and consequently the financial risk”34

. The third proposition states that debt finance is

preferential for a company’s capital structure. Although, interest deduction leads to higher after-tax income,

and, consequently, increase of individual investors taxation, debt finance is still more advantageous as it

results in tax savings35

.

To sum up, I believe that none of approaches, purely legal or purely economic, is not essential for tackling

hybrid finance mismatches. But, combination of legal and economic point of view can be very helpful. Legal

assessment of hybrid financial instruments must be connected with and based on economic reality. In next

subchapter I would like to indicate main tax consequences of hybrid finance and why proper assessment is

important.

1.3. Tax consequences of hybrid financial instruments schemes

Generally, the companies choose equity or debt financing, with dividends or interests invested capital return

accordingly. Hybrid financial instruments incorporate elements of both equity and debt which results in tax

advantages in some cases. Implementation of hybrid financial instruments leads to double non-taxation or

double taxation.

1.3.1. Tax effect on inbound and outbound finance

Generally, hybrid financial instruments is used in two situations36

:

inbound finance, where recipient of investments is resident of a country and investor is outside

of this country;

outbound finance. This opposite situation, where investor is resident of a country and recipient

of investments is outside of this country.

This classification allows analyzing hybrid finance tax consequences from the territoriality principles point

of view. Thus, in case of inbound finance, subsidiary (the recipient of investments) is subject to corporate

income tax, investee (parent company) is liable to withholding tax on income originating from the

subsidiary’s country37

.

For subsidiary debt treatment is more beneficial as then it can be deducted as interest payments. On the level

of investor inbound finance leads to withholding taxation on dividends or interests38

. However, not all

33 Sasso, Lorenzo, “Capital structure and corporate governance: the role of hybrid financial instruments”, The London

School of Economics and Political Science, 2012, p. 56

34 Ibid, p. 56 - 57

35

Ibid, p. 57

36 Eberhartinger, Eva, and Martin Alexander Six,Taxation of Cross border Hybrid Finance – A legal Analysis, Vienna

University of Economics and Business Administration, 2007, p. 4

37 Eberhartinger, Eva, and Martin Alexander Six,Taxation of Cross border Hybrid Finance – A legal Analysis, Vienna

University of Economics and Business Administration, 2007, p. 4

38 Ibid

http://www.researchgate.net/researcher/80842116_Martin_Alexander_Six/


13

countries provide withholding taxation on interests. Thus, taxation on investor level may be avoided at all.

Outbound finance involves only parent company taxation. Moreover, in case of dividends distribution

withholding tax can be minimized by reduced tax rate or granted credits.

However, in both cases the key issue is how debt and equity are treated in both countries. Thus, the several

problems are identified: according to territoriality principle there is no unified classification, treatment of

debt and equity is different in countries. Moreover, indicated problems may lead to triple non-taxation (in

case of absence of withholding tax in source country39

) and triple taxation.

As possible solution provision of exemption on the level of recipient can provide a single taxation40

.

1.3.2. Hybrid instruments and tax arbitrage

Hybrid financing is also used in tax arbitrage as based on inconsistency of different tax systems the

companies try to minimize tax burden41

. Tax arbitrage utilizes cross-boarder arrangements to obtain multiple

deduction for the same expenses, a deduction in one jurisdiction and non-inclusion of income or a foreign

tax credit in another jurisdiction, and other tax benefits. Tax arbitrage takes advantage of tax treaty benefits.

Possibilities of tax arbitrage that are aggregated by hybrid financial instruments schemes are treated by the

countries differently. Some countries consider such practice as abusive, for others it is not discussable

issue42

. In order to avoid tax arbitrage an explicit international tax system could be built based on the

following principles: (1) the single tax principle, i.e. income should be taxed at least once; and (2) the

benefits principle, i.e. active businesses should be taxed primarily at source and passive income primarily by

way of residence43

. This system demands harmonization of tax systems which hardly to achieved.

Summarizing above mentioned, hybrid financing arises the following tax aspects:

withholding taxation in case of remuneration payment at source for providing funding;

taxation of remuneration for funding.

As a conclusion, the use of hybrid financial instruments in a cross-border situation is beneficial for

companies as reduces tax burden and such schemes are often used in tax structuring due to different

regulatory framework. At the same time, such schemes lead to tax risks, in particular, risk of transaction

reclassification by tax authorities.

1.4. Short summary of the Chapter

In this chapter I indicated the problem related to hybrid financing, in particular, qualification conflict.

Qualification conflict is caused by different treatment of debt and equity in different countries. The problem

takes place not only in tax legislation field but in civil law and accounting as well. Moreover, each of these

disciplines treats hybrid instruments contradictory. This fact makes qualification conflict even more

39 Ibid, p. 5

40 Ibid, p. 5

41

Rafael Minervino Bispo, “Brazil/United Kingdom/United States Cross-Border Intra-Group Hybrid Finance: A



42 F.A. Garcia Prats, “Qualification of Hybrid Financial Instruments in Tax Treaties”, Universitat de Valиncia, p.995

43 Ibid

14

complicated.

The qualification conflict is closely related to debt and equity distinction. For these reasons, I also analyzed

main features of debt and equity in order to outline main distinction between two notions. Unfortunately,

there are no unified definitions of these two notions as well as unified approaches to distinguish them. All

these factors deepen the problems and leave fewer possibilities to regulate the issue.

These reasons should be taken into account in solving hybrid instruments problematic. The close relation to

legal and accounting areas could be useful for understanding and finding options for reform. However, direct

reference to these disciplines is not essential as law, taxation and accounting have different purposes and

their treatment lead to different consequences. In this respect the hybrid financial instruments negative tax

effect could be solved by elimination of tax consequences or through qualification conflict regulation.

In spite of negative tax consequences, from financial and commercial point of view hybrid financial

instruments have a number of advantages. In particular, these instruments are flexible, allow increasing cash

flow and providing opportunities for tax planning. These reasons explain frequency in hybrid financial

instruments usage. The hybrid financial instruments are widely used due to economic reasons. It must be

taken into account as reforms should not impact on economic activity of entities and impede business

activity. So, tax neutrality principles also should be considered in analysis of the options.

This chapter also provides analysis of main tax consequences of hybrid financing. Briefly, these

consequences include corporate tax and withholding tax optimization. At the same time such optimization is

treated as tax arbitrage in many countries, and, therefore, is considered as abusive tax practice.

Based on performed study I would like to analyze whether measures proposed by OECD can mitigate or

eliminate double non taxation caused by hybrid financial instruments schemes. In the next Chapter I would

like to describe proposed initiatives and measures.

15

Chapter 2. Initiatives proposed by OECD

In this chapter I will describe main measures and rules proposed by OECD. The purpose of this chapter is to

outline the basis for further analysis that includes valuation of efficiency, sustainability and attainability of

proposed measures and initiatives.

2.1. OECD Report “Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues”

In March 2012, the OECD published a report entitled “Hybrid Mismatch Arrangements: Tax Policy and

Compliance Issues” (the “OECD Report”), which analyzes differences in the tax treatment of instruments,

entities or transfers between two or more countries. The importance of such measures is determined by not

only influence on tax revenue, but the fact that competition, efficiency, transparency and fairness are

afflicted44

. This is caused by the effect that hybrid mismatches made. In particular, the hybrid mismatches

could result in a double deduction of the same contractual obligation. So-called deduction/no inclusion

scheme which embodies deduction in one country and non-taxation in the others45

.

The OECD approach is aimed at usage of hybrid financial instruments if qualification conflict and tax effect

are eliminated46

. Hybrid mismatch arrangements are targeted at tax burden reduction in cross-boarder

transaction by benefiting from differences in tax systems. The OECD Report concluded that although

identification of which country loses tax revenue, both country involved in hybrid scheme are carrying risk

of unfair tax benefits47

.

Under the OECD Report the following policies were considered as potential solutions:

harmonization of domestic laws, which is treated as not the best option since harmonization is

hardly to be achieved;

general anti-avoidance rules, which are considered as a good tool but mainly in respect to

artificial and intended agreements;

specific anti-avoidance rules, some countries introduced special rules, like limitation of

payments deduction. But, not being specially oriented on hybrid financial instruments they may

have some drawback in applications;

rules specifically addressing hybrid mismatch arrangements, which provides so-called “linking

rule”. That means that treatment of instrument in one country is referred to treatment in the other

country. This option is considered as significant tool to tackle hybrid schemes48

.

As a main recommendation of the OECD Report enhancement of co-operation and information sharing could

44 Public Discussion Draft “Neutralise the effects of Hybrid Mismatch Arrangements – Recommendations for

Domestic Laws”, p. 4

45 OECD, Hybrid Mismatch Arrangements, Tax Policy and Compliance Issues, March 2012, at 7

46 Sven-Eric Barsch, Christoph Spengel, “Hybrid Mismatch Arrangements: OECD Recommendations and German

Practice“,Bulletin for international taxation, October 2013, section 4

47 Tax: Addressing the hybrids,

http://www.oecdobserver.org/news/fullstory.php/aid/4278/Tax:_Addressing_the_hybrids.html

48 OECD, Hybrid Mismatch Arrangements, Tax Policy and Compliance Issues, March 2012

16

be determined as it allows to trigger rules adoption and make them more effective49

.

It should be noted that OECD Report contains just policy, but not detailed rules to tackle with hybrid

financial instruments abusive tax practice. It indicates problems, highlights potential measures and analyzes

the rules applied by some countries. It is also helpful for further development that the OECD Report outlines

the policies and measures for tackling abusive hybrid practice. Ideally, all of them can be efficient and

sustainable for tax effect elimination. However, OECD Report could not be properly estimated as it is not

enough for elimination of negative tax consequences caused by hybrid finance, and further rules developing

is in the process. It is also noteworthy that OECD Report covers all types of hybrid mismatches, and

proposed measures and policies are broad. Thus, more specified rules are needed. The above mentioned ideas

were developed by BEPS.

2.2. BEPS. Action 2. Neutralize the Effects of Hybrid Mismatch Arrangement

Tax avoidance issues being hot topic for international tax society as of now ended up with the OECD “Base

erosion and profit shifting” report of February 12, 2013. Action 2 “Neutralize the Effects of Hybrid

Mismatch Arrangement” (hereinafter – Action 2) provides measures to tackle abusive hybrid instruments

schemes.

The Action 2 provides general measures to be applied with respect to hybrid financial instruments50

:

changes to the OECD Model Tax Convention to ensure that hybrid instruments and entities (as well

as dual resident entities) are not used to obtain the benefits of treaties unduly;

domestic law provisions that prevent exemption or non-recognition for payments that are deductible

by the payor;

domestic law provisions that deny a deduction for a payment that is not included in income by the

recipient (and is not subject to taxation under controlled foreign company (CFC) or similar rules);

domestic law provisions that deny a deduction for a payment that is also deductible in another

jurisdiction; and

where necessary, guidance on co-ordination or tie-breaker rules if more than one country seeks to

apply such rules to a transaction or structure.

Importance of BEPS report is discussed and argued. Some may say that it is more political oriented and it

allows countries to stay in cooperation and develop international tax regime, others point out that importance

of BEPS is supported by necessity of changes.

Measures indicated under Action 2 are not enough specified and real reforms are to be developed. It is fairly

indicated that in any solution to be reached one of the country will lose51

.

49 PwC report, Tax Policy Bulletin, OECD Report – Hybrid Mismatch Arrangements: Tax Policy and Compliance

Issues, April 2014, p. 2

50 OECD, “Base erosion and profit shifting”, Action 2 “Neutralize the Effects of Hybrid Mismatch Arrangement”, 12

February 2013, p. 15

51 Yariv Brauner, “BEPS: An Interim Evaluation”, World Tax Journal, 2014 (V.6), # 1, 4 February 2014, section 2, p. 6

17

Besides, there is no unified approach whether domestic rules or general anti-abuse rules should be introduced

to tackle hybrid mismatches. General anti-avoidance rules are useful and effective in tackling with artificial

arrangements but unintended transactions still will be not covered52

. Some countries developed their own

rules to curb abusive hybrid mismatches which could be considered as positive. Generally, such rules can be

grouped in the following way53

:

multiple deduction of the same expenses;

deduction of payments that are not included in the taxable income of the recipient;

non-inclusion of income that is deductible at the level of the payor;

abusive foreign tax credit transactions.

The main mismatches identified under Action 2 are (1) payments are deductible at the level of payer and

non-taxable at the level of recipient, and (2) payments that are deductible at the both level. Taking these into

account legislators can develop effective rules to tackle hybrid financial instruments.

The same as OECD Report BEPS does not specify any detailed rules or measures that could solve

qualification conflict or provide guidance on hybrid instruments taxation. From my point of view, the raised

problem is quite deep and specific and demands significant efforts. Taxation of hybrid instruments could not

be based only on general measures and principles. It requires specifically addressed rules that taking into

account problematic of hybrid mismatches. Draft of such rules was developed by OECD.

2.3. The Public Discussion Drafts were released, BEPS Action 2: Neutralize the Effects of

Hybrid Mismatch Arrangements (Treaty Issues)

2.3.1. Scope of the Draft and underlined principles

In the framework of the BEPS Public Discussion Drafts were released, BEPS Action 2: Neutralize the

Effects of Hybrid Mismatch Arrangements (Treaty Issues) (hereinafter – the Draft). The Draft is aimed at

only tax issues and results related to hybrids. Others issues, like legal uncertainty or accounting purposes, as

well as their influence on tax outcomes are not considered.

The Draft points out that hybrid mismatch rules should be applied only if hybrid scheme leads to

mismatches.

In order to be effective the hybrid mismatch rules should meet the following criteria54

:

operate to eliminate the mismatch without requiring the jurisdiction applying the rule to establish

that it has ‘lost’ tax revenue under the arrangement. This method allows avoidance of the practical

and conceptual problematic related to intended and unintended mismatches. Some domestic rules are

applied only to transactions aimed at tax benefits as to eliminate negative tax effect. Implementation

of set of linking rules simplifies hybrid mismatches taxation55

;

52 Raffaele Russo, “The OECD Report on Hybrid Mismatch Arrangements”, Bulletin for International Taxation, 2013

(Volume 67), No. 2, 7 January 2013, section 5

53 Ibid

54 OECD, Public Discussion Draft “Neutralize the effects of Hybrid Mismatch Arrangements – Recommendations for

Domestic Laws”, 19 March 2014 – 2 May 2014. p. 10

55 Ibid, p.11

18

be comprehensive. Lack of comprehensiveness could result in additional compliance costs and

provide with further tax planning opportunities. Hybrid mismatches rules should not leave any

opportunities to be exploited. Thus, the Draft advices to develop sufficient set of rules on a stand-

alone basis without reference on other country jurisdiction56

. Importance of hierarchy of rules is also

stressed in the Draft;

apply automatically. The hybrid mismatches rules should be applied without tax authorities’

initiation. Rules requiring notion or applied under someone discretion make more complicated and

less effective;

avoid double taxation through rule co-ordination. The Draft proposes the following requirements: (1)

consistent and proportionate application; (2) consistency with other domestic rules; (3) co-

ordination with rules in third jurisdictions. Co-ordination also embodies interrelation with other anti-

avoidance rules;

minimize the disruption to existing domestic law. Hybrid mismatch rules should not impede

domestic rules, as well should not neutralize their effect. This is possible due to re-characterization.

However, re-characterization should be applied only for hybrid mismatches prevention purposes and

it is not necessary tool;

be clear and transparent in their operation. These characteristics are also important as application of a

rule should not be burdensome from administrative point of view;

facilitate co-ordination with the counterparty jurisdiction while providing the flexibility necessary for

the rule to be incorporated into the laws of each jurisdiction. To make rules effective it is crucial to

ensure their operation on the same entities and payments in both jurisdictions. The rules also should

be flexible to fit with domestic system. The Draft provides that it is achievable through the neutral

definitions and terminology57

;

be workable for taxpayers and keep compliance costs to a minimum. The rules should not raise

compliance costs for a taxpayer in order to be effective. At the same time the problem is the

measurement of compliance costs. It can depend on how the rule is addressed. Thus, not clear

drafting can lead to additional burden for a taxpayer. It is noteworthy that reduction of compliance

costs is easier to achieve through multilateral agreements as coordination between countries is more

effective than in case of unilateral approach;

be easy for tax authorities to administer.

2.3.2. The proposed rule

The Draft provides description of hybrid mismatches. In particular, it identifies basic kinds of hybrid

financial agreements: basic hybrid financial instruments, hybrid transfer, and other kinds of hybrid

mismatches. The thesis is focused on the analysis of the basic financial instruments. The Draft considers as

56 OECD, Public Discussion Draft “Neutralize the effects of Hybrid Mismatch Arrangements – Recommendations for

Domestic Laws”, p. 11

57 Ibid, p. 13

19

hybrid financial instruments the following scheme58

.

A company B Co (hereinafter –В Со), which is an entity resident in Country B, issues a hybrid financial

instrument to a company A (hereinafter – Co), which is an entity resident in Country A. The instrument is

treated as debt for the purposes of Country B law and Country B grants a deduction for interest payments

made under the instrument, while Country A law grants tax relief (an exemption, exclusion, indirect tax

credit, etc.) in relation to the interest payments received under that instrument59

.

As a result of such difference a payment of deductible interest by the issuer is treated as a dividend which is

exempted from the charge to tax in the holder’s jurisdiction or subject to some other form of equivalent tax

relief.

The Draft has developed the following rule60

:

a) A dividend exemption should not be granted under domestic law to the extent the payment is a deductible

payment. This allows elimination of any mismatches. The Draft also recommends changes in withholding tax

rate relief granted at source so relief should be in proportion to net taxable income.

b) Under the linking rule, the payor jurisdiction would deny a deduction for any payment to the extent the

payee is not required to include the payment in ordinary income61

. Under the defensive rule, the payee

jurisdiction would require inclusion in ordinary income to the extent the payor jurisdiction allows for a

deduction (or equivalent relief) of the payment made under the hybrid instrument62

.

With respect to these provisions the Draft advises to limit exemption for dividends under domestic

legislation to the payment has borne underlying tax63

. That involves modification of dividends definition

according to domestic law. When the dividend exemption is denied there will be no mismatch in tax

outcomes to which the linking rule can apply and no circularity will arise under the recommended rules64

.

58 Public Discussion Draft “Neutralize the effects of Hybrid Mismatch Arrangements – Recommendations for

Domestic Laws”, 19 March 2014 – 2 May 2014, p. 19

59 Ibid p.19

60 Ibid, p. 25

61 EY Global Tax Alert, OECD releases discussion drafts on neutralizing hybrid mismatches arrangements under

BEPS Action 2, 7 April 2014, p. 4

62 Ibid



64 Ibid

20

There are two key limitations to the designed rule65

:

1. The first limitation is aimed at definition and ascertains that the mismatch is attributable to a hybrid

element in the financial instrument itself. The Draft advises to identify hybrid elements by elimination.

Referring to the terms of the transaction leads to tax mismatches.

2. The purpose of second limitation is neutralization of mismatches effect.

The Draft points out that for efficiency of the rule definition of hybrid financial instruments should be

determined. At the same time this definition should be broad in order to cover all potential hybrid

instruments.

2.3.3. Definitions of payments and effect of the designed rule

The Draft specifies what exactly should be included into “payment” and “ordinary income”, its recognition,

deductibility and other issues.

The rule should lead to re-characterisation of the payment in order to achieve the same treatment as in

counterparty’s jurisdiction. Thus, if the payee’s jurisdiction treats a portion of the payments made under

instruments of that nature as giving rise to an exclusion or exemption (or to foreign tax credits) then the same

proportion of the payments under that instrument should not be treated as a deductible expense of the

payer66

. Otherwise, it should be treated as ordinary income.

The Draft also analyzes the effect on basic hybrid financial instruments. Country of dividends holder will

deny their deduction if dividends were deducted by issuer. In most cases, this should be sufficient to

eliminate the mismatch attributable to a dividend exemption and there would be no need for Country A or

Country B to apply the hybrid mismatch rule67

. In case of hybrid mismatch rule application, dividends holder

country should reclassify the payments made under the instrument as ordinary income to the extent such

payment gave rise to a deduction under the laws of issuer country.

The Draft indicates that received payments should not be subject to dividends exemptions68

. Determining

scope of hybrid financial rule tax policy and tax administration are taken into account. It is embodied

indication of kinds of transactions to be covered by the rule and rule's application and enforcement69

.

2.3.4. The scope of the designed rule. Bottom-up and top-down approaches

Ideally, applicable approach includes distinction between intended and unintended arrangements as well as

evaluates necessity of information exchange. The Draft specifies two applicable approaches to the scope of

the rule:

“Bottom-up” approach, which is aimed at identification of the most significant concerns from a tax

65 Ibid, p. 28



67 Ibid , p. 31

68 Ibid, p. 32

69 Ibid, p.32

21

policy perspective70

. Under this approach transactions between related parties and “deliberate”

transactions (so-called “structured transactions”) will be tested. One of the main drawbacks of such

approach is possibility of exclusion of unintended or accidental mismatches.

"Top-down” approach, which covers all hybrid mismatches, but following exclusions are applied. Such

approach is seemed to be more comprehensive.

2.3.4.1. Bottom-up approach

2.3.4.1.1. Applicable parties

With respect to “bottom-up” approach general requirements to the rule include the following. The rule is

applied to the instruments held by related parties (including persons acting in concert). The related party test

also includes the parties have a material interest in engineering a particular tax outcome and there are

coordination mechanisms in place that allow them to undertake collective action (i.e. acting in concert)71

.

The Draft determines the related persons if the first person has a 10% or more investment in the voting rights

or value of a second or a third person has a 10% or more investment in vote or value in both72

. The Draft

presumes the threshold to be low. The term “related party” can be broadened by the domestic legislation as

well as 10% threshold can be adjusted by a company.

Person “acting in concern” presumes the voting rights of that person or the value of any equity interests of

that person. Two persons will be considered as acting together in concern in case of the following

conditions73

:

they are members of the same family;

one person acts in accordance with another’s wishes regarding ownership or control of those

rights or interests, or has entered into an arrangement to that end; or

the same person or group of persons manages ownership or control of those rights or interests.

2.3.4.1.2. Structured arrangements

The Draft specifies that the designed rule will apply to hybrid financial instruments that are a part of a

structured arrangement. To identify whether arrangement is considered to be structured the Draft outlines

some characteristics74

:

an arrangement which was developed to exploit differences in the tax treatment; determined as a

tax-advantaged product or targeted to investors that would benefit from the tax arbitrage;

the pricing of the arrangement considered sharing of the tax advantages or the expected tax

70 Ibid, p. 33



72 EY Global Tax Alert, OECD releases discussion drafts on neutralizing hybrid mismatches arrangements under

BEPS Action 2, 7 April 2014, p. 5

73 Ibid



22

benefit of a mismatch;

the tax benefits are significant in proportion to the non-tax business and financial consequences

of the arrangement;

the arrangement involves factors treated as tax-motivated structured products;

there are collateral arrangements or terms embedded in the instrument that alter the economic

return under the instrument in the event that the tax benefit is no longer available.

The Draft considers these factors as markers that a mismatch leads to negative tax effects. The Draft

indicates that this list is not final version and need to be developed. In particular, it requires substance and

testing of details of a transaction.

The Draft also analyzes pros and cons of “bottom-up” approach. It is precisely targeted, not burdensome

from compliance and administrative point of view and there is no need to determine the instrument (widely-

held and traded)75

. All these makes “bottom-up” approach more advantageous. However, lacks of flexibility,

necessity of definitions (like related parties, parties acting together and structured arrangements) are

disadvantages of this approach76

.

2.3.4.2. Top-down approach

This approach can be described as broaden as it starts with all-transaction inclusion and following

application of exemptions. With respect to “top-down” approach three steps could be pointed out77

:

scope, which includes all transactions;

exceptions;

above mentioned exceptions are not applied if arrangements are entered into between related

parties/acting in concert or are structured arrangements.

“Top-down” approach is considered to be more comprehensive and flexible, not demanding any definitions

(which is less burdensome from the administrative point of view). At the same time it requires a significant

amount of compliance and information requirements. Moreover, new definitions for widely-held instruments

as well as others definitions in the framework of step 3 are required78

.

2.4. Brief summary of the Chapter

As a conclusion for this Chapter, I would like to point out that the OECD Report and BEPS plan provide

only general policy and do not specify any details. However, the general policy and measures are important

and can be a good starting point for further development. First of all, the main policy is necessity of

coordinated work, co-operation and information sharing. Secondly, BEPS plan raised discussions about the

hybrid financial taxation and many risky areas and issues for consideration were identified. At the same time



76 Ibid

77 Ibid, p. 38

78 Ibid

23

the main drawback of these documents is that both are too broad and do not specify characteristics of hybrid

financial instruments. They just superficially outline the problem without examining qualification conflict

which is core element of hybrid financial instruments. In addition, there is no indication or analysis on what

level the problem should be solved and whether it includes reference on legal and/or accounting treatment.

Mainly, documents describe double non-taxation effect of hybrid financial instruments, but double taxation

is less outlined or presumed to be regulated under other Actions of BEPS plan. However, double taxation is

one of hybrids instruments consequences and serious obstacle of globalized economy and could not be

excluded.

Within these documents the Draft was developed. I believe that it is a great progress and this document

raised and highlighted essential issues. At first instance, it provides with a draft of a rule and analyzes

potential effect. One of the other essential issues is the main principles that should base the hybrid financial

rule. Even if proposed model is not adopted, these principles can be a good ground for work in future. Based

on the above the analysis of proposed measures, policies and rule will be done in the next chapter. The Draft

consists of different approaches and definitions that need to be adjusted or expanded. At the same time it is a

huge step forward. Proposed principles, definitions, approaches and a rule itself are a good start for further

work.

It is important to mention that all initiatives indicate main principles for tackling hybrid mismatches. The

OECD Report indicates that fairness, competition, efficiency, transparency are affected.

The BEPS plan specifies only general measures that should be detailed and transformed into rule. The Draft

proposes quite detailed principles. My opinion is that these principles and theories should be good base for

any rule that will be adopted.

Talking about the rule proposed by the Draft, I would like to add that the initiative and the outlined issues

and problems are quite determined and well identified. I believe that based on this ground effective rule can

be developed. More precise analysis will be performed in the following chapter.

Chapter 3. Analysis of proposed measures

In the Chapter 2 I briefly described the measures developed by the OECD Report and BEPS plan and

hybrid mismatches rules proposed by the Draft. In the following chapter I will analyze these measures

and rule. It is important to highlight the benchmark or markers for estimation of new rules. As it fairly

mentioned by Keidanren, in the process of development and implementation of rules for preventing

tax avoidance, such rules should neither obstruct business activity nor be burdensome for a taxpayers

and tax authorities79

.

As it was mentioned in the chapter 1 one of the tax consequences of hybrid financial instruments is

double taxation which is eliminated by double tax treaties and international principles. My analysis

will be performed from international tax principles perspectives.

International tax law is more principle based and compliance with these principles play significant

role in achieving neutral and fair taxation in cross-boarder transactions. Tax economic neutrality is

also essential as non-neutrality impedes cross-boarder business activity.

The Draft also identifies main criteria for proposed rules that I described in Chapter 2. I believe that

these criteria are also applicable for any rule addressed to hybrid mismatches and should be taken into

account in estimation of rules.

I would like to start with brief summary of main international tax principles.

3.1 Principles applicable to the cross-boarder transactions

3.1.1 Source and residence taxation

Income gained from international activity is taxed based on the source approach (income is taxed

where it was earned) or based on residence approach (income is taxed where the person who receives

income is resident)80

.

Each method has its purposes. So, residence approach protects primarily interests of resident

countries. This principle is explained by the necessity to contribute to the country that provides a

residence, without any link to income generation.81

. Residence is common ground for imposition of

taxing rights. However, mere fact of residence does not create income. Residence is more about

justifying consumption of income and capital rather production of them82

. This is more obvious in

relation to hybrid financial instruments taxation as receiver of interests or dividends do not create any

activity in order to receive this remuneration. Thus, taxation of hybrid financial instruments

remuneration is not quite fair.

Source based approach is aimed at supporting interest of the country where income was deprived

79 http://www.keidanren.or.jp/en/policy/2014/041.html

80 Reuven Avi-Yonah, “Tax justice briefing – source and residence taxation”, Tax Justice network, 15

September 2005, p.1

81 Ibid

82 Kemerren E.C.C.M., Principle of origin in tax conventions, Dongen (The Netherlands), August 2001, p.32

from83

. Justification of the source principle is that income physically arises within the territory of the

state. It is also indicated that nature and source of income are connected and dependent on each other

as source of income is raised from its nature.84

There is no unified definition of “source”. In particular, as a “source” location of property, place of

service performance, place of contract singing or executed could be considered85

. This variety of

“source” interpretation is a disadvantage since the same definition is construed in different ways and it

gives uncertainty. The other drawback of this principle is that income can be produced in the other

state than a state from which income was received.

Both principles have its disadvantages, especially in respect to developing countries. Developing

countries are usually source countries, and residence taxation demotivates developing countries as it

deprives a part of revenue86

. At the same time, application of only source taxation can lead to

overstating of costs87

.

Meanwhile, OECD adheres to residence base taxation and limits taxation at source.

Although these principles are considered to be neutral, both of them have discriminatory features88

.

Residence is applied to residents and means worldwide, unlimited taxation. Source taxation is limited

and applied to non-residents. In this respect the neutrality principles also should be taken into account.

Principles of allocation of taxing rights are very important in relation to hybrid instruments taxation.

The companies use differences in tax systems, and obtain deduction in source State and participation

exemption in residence State89

. Thus, principles that are aimed at regulation and fair allocation of

taxing rights, in fact, only aggregate problems and give an opportunities for abusive tax planning.

In this respect I would like to consider origin principle that can be a solution for fair allocation of

taxing rights.

3.1.2 Principle of origin

Principle of origin embodies taxation in the state where income was produced90

. The difference

between source and origin principles is that origin principles allows taxation at the state of production

of income, while for source based taxation place of production is not dominant91

. Principle of origin

has strong connection with the direct benefit principle. It is arguable where income should be tax: at

the place of residence as a resident brings value to the budget or at the place of income production. An

additional argument is that simple residence does not generate income. The place of income origin can

83 Reuven Avi-Yonah, “Tax justice briefing – source and residence taxation”, Tax Justice network, 15

September 2005, p.1

84 Kemerren E.C.C.M., Principle of origin in tax conventions, Dongen (The Netherlands), August 2001, p.37

85 Ibid, p.33

86 United nations Conference on trade and development, “Taxation”, 2000, p. 52

87 Ibid, p. 52

88 Terra B.J.M, Wattel P.J, “European Tax Law”, 2012, p. 130

89 Patricia A. Brown, “Abuse of Tax Treaties:Defining the Problem to Develop Effective Solutions”,

University of Miami School of Law

90 Kemerren E.C.C.M., Principle of origin in tax conventions, August 2001, p.35

91 Ibid, p.36

be considered as the place where added value was created.

Authors rely on the statement that connection of state and produced income is clear than connection

with source state which is not generally determined92

.

There are debates what is considered as place of origin and place of source. In particular, two links are

mentioned: “the intellectual element” and “human relations”. Scholars point out that it is essential to

determine by whom intellectual element is recognized. “Intellectual element” can be recognized by

the recipient, or its personnel, agents, independent person, etc. Some concerns regarding taxation of

passive income based on origin principle were expressed. In particular, as a negative consequence,

principles of origin can result in international juridical double taxation and obstruct free movement of

capital93

. Taxation based on residence is considered to be more neutral from investment point of

view94

. However, as a counterargument it should be mentioned that taxation at the level of resident,

creditor, also could impact on neutrality95

. Besides, double tax treaties are a good solution for tackling

double taxation.

Principle of origin also includes limitation. In particular, not all income produced in a state is

presumed to be taxed in that state, but sufficient. The following characteristics can describe

sufficiency of income96

:

the portion of activities performed in a state in comparison with the whole business,

involving quantity and quality of production factors;

the nature of activities;

the contribution in the state.

As discussed above taxation of interest and dividends based on source and residence principles and

different treatment of debt and equity may lead to tax abuse and treaty shopping.

In the framework of qualification conflict, remuneration for both types of financing, debt and equity,

should be allocated to the state where funds were used to generate business profit97

. Thus, origin

based taxation provides neutrality to these types of cross-boarder transactions98

.

Principle of origin can be a good solution to combat tax avoidance and abusive tax practice as it

relates to sufficient income produced at a state, but not residency. This principle is also efficient in

prevention of international tax fraud as disclosure of information is much easier in the framework of

origin principle99

.

92 Kemerren E.C.C.M., Principle of origin in tax conventions, August 2001, p.37

93 Ibid, p.41

94 Ibid

95 Ibid

96 Ibid, p.44

97 Ibid, p.434

98 Ibid

99 Ibid, p.45

3.1.3. Economical principles

In order to achieve economical efficiency in cross-boarder transactions market should be neutral.

International economical society utilizes the concept of capital import neutrality and capital export

neutrality. These principles are aimed at neutrality of market and closely connected with residence and

source taxation. Achievement of fair and neutral economical environment is one of purposes of the

EU community. As it was indicated hybrid financial instruments are widely used due to financial and

business reasons. Thus, hybrid mismatches rule must be in compliance with these principles as well.

Below I would like to briefly describe tax neutrality principles, CIN and CEN.

3.1.3.1. Capital import neutrality

Capital import neutrality concept can be described as treatment of investments within a country

irrespective of investor’s residence (domestic or foreign)100

. CIN is common for countries based on

source principle. This principle is advantageous for foreign investment as domestic and foreign

investments are treated equally.

CIN could be achieved by granting exemptions to foreign source of income, and imposing taxes only

by the foreign state101

.

3.1.3.2. Capital export neutrality

CEN is a concept which presumes that a resident's investment should be treated equally regardless of

origin location (domestic and abroad)102

. As an example, a home State imposes taxes on foreign

income and domestic income at the same level. CEN is implemented in a residence-based tax

system. In the framework of this system a resident is provided with credits, i.e. he is allowed to deduct

home tax on the amount of the foreign tax already paid in the source State103

. Foreign income is taxed

according to domestic tax rules as if it was domestic-source income. This leads to the situation that all

residents pay taxes in their country independently whether the investment was domestic or foreign.

CEN can be achieved if countries will impose taxes only on their residents by granting unlimited tax

credits104

. In such a case a resident pays taxes both on domestic and foreign investments according to

his home state's legislation.

The tax neutrality principles play important role in relation to hybrid financial instruments. Taxation

of hybrid financial instruments is in conflict with capital export neutrality because taxation of hybrid

instruments is more burdensome in cross-boarder arrangements then in domestic one. At the same

100

IBFD International Tax Glossary

101 Peter Hordijk, “UK Double tax relief. Disparity or harmful restriction?” Issue: EFS topmaster direct taxes

2007, p. 3

102 IBFD International Tax Glossary.

103 Peter Hordijk, “UK Double tax relief. Disparity or harmful restriction?” Issue: EFS topmaster direct taxes

2007, p. 2

104 Ruth Mason, “Tax Discrimination and Capital Neutrality”, Issue: World Tax Journal, 2010 (Volume 2), No.

2, Published online: 10 May 2010, section 4.

time capital import neutrality is also not complied since other investors in foreign country are in less

advantageous position as hybrids' investors.

Bearing in mind above mentioned international principles, policies and standards I would like to

analyze published initiatives.

3.2. Analysis of ”Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues”

The attention of OECD to hybrid financial instruments recognizes that it is one of the most

complicated tools for tax planning. The multinational companies use hybrid financial instruments as

to lower worldwide tax burden, which results in tax avoidance.

As described above the OECD Report points out the following solutions:

harmonization that ideally will eliminate differences in the tax treatment. But the global

harmonization is difficult to be agreed105

;

general anti avoidance rules that are embodied in such techniques as “abuse of law”,

“economic substance”, “fiscal nullity”, “business purpose” or “step transactions” can be a

comprehensive solution106

. The main disadvantage is their unified character and potential

inefficiency in case of unintended double non-taxation. This measure is also not

preferable as it would create unnecessary uncertainty and hinder economic growth107

.

However, there is another opinion that general anti-avoidance rules can be a great starting

point. In order to be a good guidance such rules should be structures clearly and provide

certainty108

;

specific anti-avoidance rules could be a better solution. Under this measure a “linking

rule” is proposed. However, it is a general measure, not directly targeted at hybrid

mismatch arrangements. In addition, such rules are quite complicated. It is also indicated

that “linking rules” require implementation of tie-breaker rule which is important to deal

with tax systems of different countries109

. At the same time authors point out that tie-

breaker rule is not obligatory provision, and some countries do not have it110

. In addition,

introduction of different, not unified rules, may aggravate situation. Along with it, the fact

that “circular linking rules” potentially may make hybrid finance more complicated, such

rules are widely used, for example, controlled foreign company rules111

. Moreover,

105 Gabriel van Gelder, Boudewijn Niels, “Tax treatment of hybrid finance instruments”, Derivatives &

Financial instruments, July/August 2013, section 2.2

106 Ibid

107 International Chamber of Commerce, Commission on Taxation, «Comments to the OECD Discussion Draft

Action Point 2 “Neutralise the Effects of Hybrid Mismatch Arrangements”, 2 May 2014, p. 6

108 Swiss Banker Association, Discussion draft on Action 2: Neutralise the Effects of Hybrid Mismatch Ar-

rangements (Recommendations for Domestic Laws), 30 April 2014, p. 2

109 OECD, Hybrid Mismatch Arrangements, Tax Policy and Compliance Issues, March 2012

110 Dr Kasper Dziurdź, “Circularly Linked” Rules Countering Deduction and Non-Inclusion Schemes: Some

Thoughts on a Tie-Breaker Test“, Bulletin for international taxation, June 2013, section 1

111 Ibid

specific rules can be difficult to implement due to their complexity, and thus lead to less

effectiveness112

.

The practitioners suggest that the OECD Report summarizes problems and proposes possible

solutions that are based on the best practice113

.

Based on summary provided in the Chapter 2 and analysis performed above, OECD Report can be

considered as a principle based document. In particular, the measures are not concrete or specific

enough to eliminate negative tax consequence of hybrid mismatches and tackle tax avoidance. From

my point of view it essential to identify problematic correctly as it allows to address the rule precisely.

Outlined policies are quite broad but could not be specifically estimated. At the same time, the

proposed guidance for curbing abusive hybrid mismatches practice is in line with established

international and economical tax principles. All of policies are aimed at removal of any obstacle to

opened, globalized market and establishment of competitive and fair economic environment. These

rules and policies that are aimed at eliminating negative tax effect of hybrid mismatches can be a great

tool for establishment tax neutrality in making decision regarding investments.

3.3. BEPS.Action 2. Neutralize the Effects of Hybrid Mismatch Arrangement

The scholars have different view at the BEPS plan as whole project and at Action 2 as well. BEPS

plan is seems to be reliable standard for preventing double -taxation in cross-boarder transaction and

provide prosperous and advantageous climate for business and investments114

. At the same time, as

some authors indicate BEPS measures are mostly aimed at less – manufacturing countries (so-called

“tax heaven”) as manufacturing countries suffer BEPS115

.

Authors also point out that mostly OECD projects have indirect influence. In particular, BEPS plan is

more recommendation document rather direct detailed guidance116

.

This is supported by the fact that BEPS’s goals and scopes are not clear117

. It is also indicated that

current rules are not sufficient enough. Mostly, they are based on allocation principle (source or

residence), and can be not competent in more complicated and specific cases118

. Thus, to solve profit

shifting problems more sophisticated rules and communication between tax authorities are required119

.

In order to achieve this goal reforms should be more integrated and complex.



113 PWC Tax policy bulletin, 15 September, p. 3, www.pwc.com/taxpolicy

114 Michael Plowgian, “BEPS: The Shifting International Tax Landscape and What Companies Should Be

Doing Now“, “The tax executive”, p. 256

115 Yariv Brauner, “BEPS: An Interim Evaluation”, World Tax Journal, 2014 (V.6), # 1, 4 February 2014,

section 1, p. 2




section 1, p. 2

118 Ibid 119 Ibid

At the same time, the BEPS plan is not aimed at tax harmonization. So, development of detailed rule

is not primary purpose of the document. The BEPS plan is more like an mechanism for solving

addressed problems120

.

As one of the BEPS's principles the following could be considered – low taxation is only a problems

when income artificially separated from value created121

. The principle of sovereignty also should be

mentioned. It is country's right to impose taxes, not international community. The OECD and the

BEPS plan deal with artificial shifting of profit and escaping of taxation.

It is noteworthy that BEPS plan is not aimed at allocation of taxing rights between residence and

source countries. It is intended to support both types of taxation in case of cross-boarder transaction is

untaxed122

. At the same time, analyzing measures proposed by Action 2, some authors indicated that

source of income should be taken into account123

. Otherwise, any measures will be inefficient.

However, potentially it will be residence based taxation with foreign tax credits as residence taxation

is an approach adopted by OECD.

In any case, to make BEPS plan more effective contracting parties need to reach unanimity at greater

extent.

It is commonly mentioned that the main problem of hybrid instruments is difficulties in identification

of them124

.

All Actions of BEPS plan are interacted and connected with each other. The practitioners believe that

measure adopted under Action 2 should be in compliance with all others Actions, otherwise, hybrid

mismatches rules can lead to non-neutral or unequal treatment125

. So, it is proposed to formulate rules

and determine mismatches accurately126

.

It is also noteworthy that the hybrid mismatches rule is aimed at consequences, not a primary purpose

of transactions, and unified rule can be a better solution than proposed by the Draft127

. Besides, some

countries, for example, UK, Germany, Denmark, have adopted domestic rules targeting hybrids

instruments128

.

The practitioners indicate that the BEPS plan is considered as a framework129

. The hybrid mismatches

rule should be in consistence with all other measures.

The BEPS plan develops ideas and policies established by the OECD Report. There are some



121 Ibid

122 Ibid


section 2


125 International Chamber of Commerce, Commission on Taxation, «Comments to the OECD Discussion

Draft Action Point 2 “Neutralize the Effects of Hybrid Mismatch Arrangements”, 2 May 2014, p. 1

126 Ibid

127 Ibid


129 Ibid

uncertainties regarding efficiency of proposed solutions. Firstly, the extent of BEPS's involvement

into business activity. From my point of view, it is fair that BEPS's rules are supposed to be applied in

case artificial arrangements and are not targeted at all hybrid instruments. This allows performing

business activity freely.

One of the important issues is allocation of taxation rights. The BEPS plan does not determine what

type of taxation should be taken in respect of hybrid mismatches. I believe that this is very important

as the hybrid arrangements are used between so-called “tax heaven” countries and manufacturing

countries. Both of the principles can lead to unfair imposition of taxing rights and, consequently,

discourage investments or, other way round, transfer tax burden on manufacturing countries.

3.3. The Draft

3.3.1 General positions

The Draft is mainly based on the OECD Report, especially in the part of policy and general principles.

The Draft includes a rule that can be implemented in to OECD Model Tax Convention. In order to be

effective, proposed rules should be adopted by all members. The scope of the Draft targets only tax

effect is supported by the practitioners. Exclusion of financial instruments from other areas, like legal

or accounting, analysis is a narrow approach130

. So, re characterization of transaction or treatment of

debt or equity equally in both involved states is not covered by the Draft.

The main goal of OECD initiatives is elimination of double non-taxation. However, application and

influence of these rules are not clear and could lead to double taxation131

.

The critics also advise to distinguish intended and unintended non-taxation as it is essential for

identifying tax efficiency and aggressive tax planning. In future it enables business to obtain tax

benefits without being claimed for aggressive tax planning and, moreover, it forces competition132

.

The Draft advises to apply these rules to target mismatches and to the extent of the mismatches, which

is in compliance with the BEPS plan policy. At the same time, the documents do not consist neither

the list of transactions that can be treated as abusive practice nor any criteria to identify such

transactions133

.

Some commentators state that some of proposed measures are insufficient and administratively

burdensome134

. As it was discussed there is a risk that the rule will not solve the problem and double

taxation will arise. This is obviously not the purpose of OECD initiatives. Many critics highlight that

130 Tax Executives Institute, “Comments to the OECD Discussion Draft Action Point 2 “Neutralise the Effects

of Hybrid Mismatch Arrangements”, 1 May 2014, p. 5


132 OECD center on Tax Policy and Administration, «Comments on the OECD Public Discussion Draft entitled

“BEPS Action 2: Neutralize the Effects of Hybrid Mismatch Arrangements” 19 March 2014”, 2 May 2014, p. 2


of Hybrid Mismatch Arrangements”, 1 May 2014, p.2

134 Ibid

hybrid mismatch rule may lead to double taxation as one of the consequences of tax arbitrage135

. This

is not underlined by the Draft at all. Double taxation is usually eliminated by double tax treaties. But

there are concerns that double taxation problem will be neutralized by the treaties, especially in light

of potential limits that could be imposed in the framework of treaty abuse concept according to BEPS

plan136

.

The bankers believe that negative tax effect could be neutralized if tax treatment of instruments will

be specified directly137

. This is explained by the fact that many instruments have similar structure due

to commercial and regulatory requirements138

.

3.3.2. Proposed rules

Under the Draft the rule states that dividends are exempted only in case of non deductibility of this

payment in the other country. Thus, the negative tax effect is eliminated. At the same time I would like

to point out that such rule only deals with tax issues, which are the aim the Draft. But, the

qualification conflict takes place at all level of business field, legal and accounting. In such a case,

new schemes and techniques can be developed.

The rule also provides changes in withholding tax which should be levied in proportion to net taxable

income139

.

The Draft also describes the hybrid financial instrument linking rule. As it was mentioned above

linking rule is not always applicable solution as many concerns are raised.

Introduction of the linking rule, in investor’s jurisdiction, implies changes in its controlled foreign

corporation (CFC) or foreign investment fund (FIF) rules, or specific changes to domestic laws. These

changes would be aimed at income accrued through offshore investment structures140

. On the one

hand, the main purpose of the linking rule is discouraging tax avoidance, but, on the other hand, these

rule does not identify the location and extent of base erosion and, consequently, measures to recover

tax revenue141

.

Introduction of the defensive rule, in the payor jurisdiction, would deny a deduction for a payment to

the extent the payment results in non-taxation.

The implementation of primary and defensive rules needs high level of co-ordination and

communication between countries. However, there are some doubts in achieving this consistency. In

particular, some authors indicate that the tax authorities will be able to apply defensive rule apart from

135 Universite de Lausanne, «BEPS Action Item 2: Neutralize the effect of hybrid mismatch arrangements

(Treaty Issues)», 2 May 2014, p.7

136 Ibid



138 Ibid

139 EY Global Tax Alert, OECD releases discussion drafts on neutralizing hybrid mismatches arrangements

under BEPS Action 2, 7 April 2014, p. 5

140 Ibid


primary rule142

.

Another problematic raised is potential double taxation which could be a result of deduction/non-

inclusion scheme143

. Authors also assume that denial of the deduction could lead to further

uncertainties as non-inclusion of income should be proved and confirmed144

. These issues should be

taken into consideration, otherwise, disputes with the tax authorities could be raised.

3.3.3. “Top-Down” vs. “Bottom-Up”

The Draft's scope includes a “top-down” approach and a “bottom-up” approach. The top-down

approach would apply to all hybrid mismatches, and then provide certain exceptions (e.g., for widely-

held and/or publicly traded instruments), and also exceptions to the exceptions (e.g., excepted

transactions entered into by related parties)145

. The bottom-up approach would only apply to

instruments held between related parties (including parties acting in concert) and hybrid financial

instruments entered into as part of a “structured” arrangement146

.

The “top-down” broad view can be unrealizable which is caused by the globalization of economy and

a great number of cross-boarder transactions147

. In addition, as it is indicated in the Draft top-down

approach would be burdensome from compliance perspectives148

.

The bottom-up approach also has its drawbacks. Firstly, 10% threshold is too low. It is also arguable

whether information transfer by 10%-holder is achievable. Some authors recommend increasing the

threshold to 50%, which is used for transfer pricing purposes149

. Others also support 50% threshold,

but with different reasoning. Thus, this threshold is stated by IFRS as requirement for full

consolidation150

. This is explained by the position that less then 50% of participation does not

represent full control. The Swiss Banker Association proposes that exemptions from hybrid

mismatches rule should be instruments issued and traded on stock exchange151

.

The next reason is formulation of the rule in the following way “a person who acts together with

another person in respect of ownership or control of any voting rights or equity interests will be

treated as owning or controlling all the voting rights and equity interests of that person.” This



143 Ibid

144 Ibid


Domestic Laws”, 19 March 2014 – 2 May 2014, p.38

146 Ibid, p.34




Domestic Laws”, 19 March 2014 – 2 May 2014, p.39

149 Ibid

150 Swiss Banker Association, Discussion draft on Action 2: Neutralize the Effects of Hybrid Mismatch

Arrangements (Recommendations for Domestic Laws), 30 April 2014, p. 2

151Ibid

definition is too broad. It could be applied to “all of the funds that are managed by the same

investment company and to all of the trusts managed by the same trust company”152

.

In addition, financial reporting issues should be considered. In particular, under proposed rule,

interests payments originated under debt obligation could not be deductible based on the identity and

residence of the holder of the instrument. Thus, additional issues regarding consideration of

identification of deductibility will be impose on financial reporting153

.

3.3.4. Allocation of taxing right

The allocation of taxing rights should be balanced as it allows achieving established targets. Some

commentators have concerns. If one country does not tax the revenue, another jurisdiction may

unreasonably receive taxing rights154

. In my point of view it gives opportunities for tax

manipulations. The Draft does not clearly allocate taxing rights which may lead to complexity155

.

Others indicate that credit method is preferred rather than the exemption method. However, this could

be considered as unfair treatment. Authors point out that none of the countries have priority or

preferences in allocation taxing rights156

.

3.3.5. Other issues

One of the other concerns is that such dependence of the other country treatment and, therefore,

necessity to exchange of information may lead to significant administrative and compliance costs157

.

Analyzing proposed changes, it is remarkable that application of these rules excludes unrelated

parties. At the same time, these rules require documentation of each cross-border transaction in the

involved jurisdictions, which could significantly increase compliance cost158

.

As it was many times indicated the hybrid mismatches are hard to identify. These difficulties are

explained by various reasons, in particular timing issues or accounting treatment159

. These uncertainty

and complexity are essential in both situations, in related parties and non-related parties transactions.



153 Ibid

154 OECD center on Tax Policy and Administration, «Comments on the OECD Public Discussion Draft entitled

“BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements” 19 March 2014”, 2 May 2014, p. 2

155 National foreign trade council, INC, «Comments on OECD Discussion Draft on Hybrid Mismatch

Arrangements (Domestic Law Recommendations)» , 1 May 2014, p.3

156 Otterspeer Haasnoot&Partners, Dutch and international Tax Counsel, “Comments to BEPS ACTION 2:

neutralise the effect of hybrid mismatches arrangements”, May 2014, Box 4 and 5


158 EY Global Tax Alert, OECD releases discussion drafts on neutralizing hybrid mismatches arrangements

under BEPS Action 2, 7 April 2014, p. 5

159 International Chamber of Commerce, Commission on Taxation, «Comments to the OECD Discussion Draft

Action Point 2 “Neutralise the Effects of Hybrid Mismatch Arrangements”, 2 May 2014, p.1

These issues should be considered in implementing and managing hybrid instruments rules160

.

One of the concerns is effect that can be made on economy. In particular, International Chamber of

Commerce has some doubts about influence on banking and financial services sector161

.

According to some comments the Draft is concentrated on elimination of abusive tax practice but do

not fully take into consideration potential influence on business as a whole. The process of hybrid

mismatches rule development and implementation needs time, research and accurate consideration162

.

Otherwise, influence on economy could be negative and lead to new unintended uncertainties. Hybrid

mismatches are important issue and it needs a developed and effective approach163

. The approach

should create a positive investment environment, and, ideally, taxation should not influence on

investor's decision.

3.4. Brief summary of the Chapter

Summarizing proposed measure I believe that the linking rule could be a good solution for tackling

abusive tax practice involving hybrid instruments. The rule designed by the Draft is directly targeted

at tax effect and, ideally, eliminate negative tax consequences. It denies deduction of received

payments if payment was not included at payer level. And, the payee jurisdiction would require

inclusion in ordinary income to the extent the payor jurisdiction allows for a deduction (or equivalent

relief) of the payment made under the hybrid instrument. Hence, the rule eliminates non-taxation

caused by the hybrid financial instruments. At the same time, the Draft does not analyze potential

double taxation which is also essential in cross-boarder context.

The rule could be attained as its adoption does not require significant efforts from countries as

harmonization. Some of countries have already adopted similar rules.

However, this rule results in a lot of administrative concerns. OECD does not analyze the situation as

a whole, but in respect to hybrid instruments this is essential. The rule should create and support

transparency and sustainability of economy. But, administrative difficulties and compliance costs are

burdensome for the companies.

The rule neglects qualification conflict and do not take into account legal and accounting treatment. I

believe that company law and accounting rules are essential for elimination tax effect of hybrid

instruments. But, qualification conflict as a key element of hybrids should be considered. Ignore of

different treatment of debt and equity makes the rule less sustainable and gives rise to tax

opportunities. I believe that the countries may manipulate with deduction of paid and received

remuneration choosing lower tax jurisdiction for income taxation. This also makes rule not sufficient

160 International Chamber of Commerce, Commission on Taxation, «Comments to the OECD Discussion

Draft Action Point 2 “Neutralize the Effects of Hybrid Mismatch Arrangements”, 2 May 2014, p. 1

161 Ibid

162 Ibid

163 Ibid

enough. In addition, such manipulation may be an obstacle for economic activity and hybrid issuer

will be in more beneficial position.

The allocation of taxing rights is crucial for hybrid instruments taxation. However, it is not clear what

taxation is preferable, source based or residence based. I suppose that in these case both can result in

economical unfairness. I believe that in case of hybrid financial instruments origin principle is crucial

as it allows taxation at the place of income production. Thus, opportunity to use benefits raised by

source and residence taxation are abolished. This principle justifies taxation where the income was

produced.

As hybrid instruments involve qualification conflict in many areas, legal, tax, accounting, I believe

that regulations only at tax level could not be efficient solution. However, to harmonize all these areas

is impossible.

Chapter 4. Alternative solutions

Tax benefits applicable through hybrid financial instruments schemes are caused by qualification

conflict, various treatment of the same arrangement in different jurisdictions. There are two main

solutions developed by the scholars and tax community. One is linking rule embodies that one

jurisdiction treats the instrument with reference to the other jurisdiction treatment164

. Such kind of

solution was proposed by the OECD. The another alternative is harmonization of legislation.

In this chapter I will analyze alternative aimed at harmonization of legislation. My proposal will be

based on options developed by the scholars. I will also try to support this alternative with valid tax

rules applied in different jurisdictions. However, the purpose of this chapter is identification of

alternative option and its analysis, but not study of countries tax systems and court practice. For these

purposes I will just briefly describe applicable provisions of countries tax systems.

4.1. Countries experience in tackling hybrid practice

Some countries developed domestic rules to mitigate hybrid financial instruments effect. In particular,

based on UK legislation there is no deduction in case of non-taxation of corresponding income. In

order to apply this provision the following conditions should be met165

: 1. income was generated

through a “qualifying scheme” involving hybrid instruments; 2. the main goal of transaction is tax

benefits; 3. there is a deduction against profits for a UK resident company.

According to the UK legislation received amount is not subject to tax if the following requirements

are met166

: (1) there is a scheme between parties of transaction; (2) payment is qualified as

contribution to the capital; (3) the payment is deductible as expense; (4) the received amount is

expected to be non taxable. In UK legal classification is primary, except the transaction is contrary

with its economic substance and accounting treatment167

. Distinction is based on carried risks and

nature of return. Generally, rule applied by UK is linking rule, but I believe that used requirements are

quite important for development of harmonized rule.

Dealing with qualification conflict some countries apply the “substance-over-form” approach. In

particular, USA determines whether it is debt or equity finance based on ‘facts and circumstances’168

.

Case law also plays significant role. This approach includes comparison of debt and equity features,

and based on this comparison courts make their conclusion whether it is debt or equity finance. For

distinction debt and equity the courts use various factors, in particular, expectation of payments, debt-

to-equity ratio, fixed maturity date or any conditions for payments, possibility of the holder to

control/influence on payments, existence of subordination or preference with respect to other

164 Sven-Eric Barsch, Christoph Spengel, “Hybrid Mismatch Arrangements: OECD Recommendations and

German Practice“, Bulletin for international taxation, Springer, October 2013, p. 310

165 OECD, Hybrid Mismatch Arrangements, Tax Policy and Compliance Issues, March 2012, p. 18

166 Ibid, p. 20

167 Australian government, the Board of Taxation, “Review of the debt and equity tax rules”, March 2014, p.

147

168 Ibid, p. 144

creditors, interests of the holder in shares or right to participate in control of a company, etc169

.

Australian legislation also consists of rules defining debt and equity for tax purposes. In Australia, the

test is applied based rather on economic grounds than legal form170

. The debt test analyze whether

there is a financial arrangement involving financial benefits with effective non-contingent obligation.

The test includes analysis of form of benefits (money, assets, etc.), timing of provision, receipt of

financial benefit171

.

The equity test defines whether there is172

:

An interest in a company as a member of shareholder;

An interest includes fixed returns from the company;

An interest issued by the company and it gives right to be issued with an equity interest or

may be convert into an equity interest.

It is apparent that some countries implement rule that distinct debt and equity. The features that allow

such distinction can be grouped and used for developing harmonized rule.

In this way, brief summary shows that different countries apply various rules in dealing with hybrid

financial instruments. Some of countries follows legal classification, others base classification on

economic substance of arrangements. However, the same features are attributable to all

abovementioned measures. These features are closely related to distinctive factors. This again proves

the importance of these factors and their key role in curbing hybrid instruments negative tax effect.

4.2. Alternatives outlined by the scholars

As mentioned above in literature there are two indicated ways of elimination of hybrid financial

instruments effect. One of them is tie breaker rule. In particular, link to treatment of the instrument in

another jurisdiction could be a solution.

The second option for taxation of hybrid financial instruments is harmonized domestic tax

classification aimed at purely debt or purely equity treatment173

. Such harmonized classification

should be based on distinctive features of debt and equity and possibility to make this distinction in

practice. This rule will determine whether the instrument in question is considered to be pure debt or

pure equity financial instrument. Such determination will be based on distinctive characteristics

outlined in chapter 1. Especially because in practice several countries use main characteristics to

tackle negative tax effect of hybrid financial instruments.

At the same time tax treatment of hybrid financial instruments is influenced by legal and accounting

169 Australian government, the Board of Taxation, “Review of the debt and equity tax rules”, March 2014, p.

145

170 Eva Huang, “Identifying hybrids in Australia: comparing the TOFA debt and equity rules and AASB 132

for a definition of shareholding”, JLFM, 2010 vol 9 issue 1, p. 5

171 Ibid

172 Ibid, p. 6



treatment. It is quite important to determine at what extent harmonized rule should be affected by

company law and accounting rule.

4.3. Interrelation of harmonized rule with company law and accounting

In chapter 1 I analyzed interrelation of tax classification conflict with other disciplines, in particular,

civil law and accounting. However, I believe that it is impossible to solve qualification conflict

through reference to company law classification as different countries have various legal rules and

uncertainty will not be eliminated. Moreover, the study shows that some countries, for example, USA

and Australia, apply substance over form approach, so legal determination could not be decisive.

As it also was discussed in chapter 1, tax classification of debt and equity is influenced by accounting

rules. It is pointed out that if accounting treatment is taken into account, then only IAS/IFRS

(international accepted accounting principles) classification should be followed for the tax purposes as

domestic accounting standards are guided by company law174

. Besides, these standards are

internationally accepted and applied.

Accounting rules related to financial instruments are specified by IAS 39/IFRS 9: Financial

instruments: Recognition and Measurement .

In the framework of IAS 39, IFRS Foundation prepares working paper regarding classification of

hybrid financial instruments. In particular, there were indicated main terms and conditions for

recognition of hybrid instruments as equity. Thus, principal payment maturity is 30 years, interests

features are fixed rate (government bond plus spread) and benchmark interest rate is reset every 10

years, other requirements to specific types of instruments were also established175

.

Nevertheless, even under this working paper there is no unified approach and two views were outlined.

The first one involves firstly identification of equity and then consider the residual component of the

hybrid instrument176

. According to the second view, the host contract is identified as debt with the

stated maturity of 30 years, after identifying embedded derivatives177

.

It is noteworthy that even accounting rules do not imply unified approach. Moreover, authors point

out that link to accounting rules is rarely used in practice in many countries178

. Thus, accounting point

of view cannot be decisive in tax classification of hybrid financial instruments either, but can be

useful for the harmonized rule design. In particular, period of payment maturity could be taken into

account.



175 IFRS Foundation, “New items for initial consideration. IAS 39 Financial Instruments: Recognition and

Measurement Classification of a hybrid financial instrument by the holder”, March 2014, p.2

176 Ibid , p.3

177 Ibid 178 Sven-Eric Barsch, Christoph Spengel, “Hybrid Mismatch Arrangements: OECD Recommendations and


http://www.collinsdictionary.com/dictionary/english-thesaurus/nevertheless#nevertheless_1

4.4. Alternative solution – harmonized tax classification

Based on the analysis of these practice and main features of debt and equity, I believe that the general

rule defining debt or equity characteristics for countries to tackle hybrid finance can be developed.

Scholars also identify that the problem could be solved through establishment of a model of debt and

equity distinction and such model can contribute coherence to the problem179

. Another argument in

favour of this approach is that basically courts determine arrangement in question as debt or equity

finance without any partial treatment180

.

Based on the above I would like to outline framework of potential alternative solution which

embodies qualification conflict resolution. The harmonized rule should be purely influenced by legal

or accounting treatment as this does not bring certainty in qualification conflict. The harmonization

should be targeted at only tax classification.

In addition, as described above there are solutions to separate debt and equity in hybrid financial

instruments without negative tax effect. Moreover, there are unified and adopted rules, like thin

capitalization rule, CFC rules. So, there is a possibility to implement unified approach in some area of

taxation

4.4.1. Criteria for a rule.

As an alternative supposes dealing with qualification conflict the distinctive factors should be

indicated. As it was indicated that these factors are very important but should be aimed at

classification for the tax purposes as interest-generation or dividends-generating and not divide the

hybrid financial instruments181

. These factors have been analyzed in Chapter 1. The following

characteristics should be taken into account:

Carrying a risk is a key criterion. Debt does not give a right to participate in a

company's business, to control its activity182

. Equity is a fund of owner which could

be considered as a ground for financial growth for the business183

. The equity also

gives a power to participate in a company;

In case of equity finance remuneration is based on earnings of a company, which is

opposite to interests payments. Interests are paid in an agreed amount and in any

gained funds. Some authors indicate that fix rate is one of distinctive features of debt

finance184 ;

Subordination is also distinctive criteria. Quality of performance could result in

179 A Solution to the Debt-Equity Problem, 33 Fordham L. Rev. 239 (1964)., p. 256

180 Ibid., p.258


German Practice“, Bulletin for international taxation, October 2013, p. 306

182 Robert Flannigan, “The Debt-Equity Distinction”, Banking & finance law review, 20 January 2011, p.452

183 Capital structure: overview of the financing decision, p. 4,

Http://people.stern.nyu.edu/adamodar/pdfiles/acf3E/book/ch7.pdf

184 A Solution to the Debt-Equity Problem, 33 Fordham L. Rev. 239 (1964), p. 244

losses. Creditors have a primary of recovery in case of problems in financial position

of a company. The other view of subordination includes that subordination of

repayment to all other creditors can be considered as equity generating185

;

Returns of contributions. Equity returns are dependent on company's performance,

while in classic situation interests payments on loans are fixed and contingent;

Maturity also should be mentioned. Debt has as a rule fixed maturity, which is

opposite to equity being infinite. Fixed maturity date means that at a particular date a

holder has a right to demand payment. This is more typical for debt finance, however,

depending on terms specified in a contract, a loan can be provided for a quite long

time, more than 50 years. In this case there are concerns whether it debt or equity

based remuneration. Different duration of maturity are considered, 10, 30 and 50

years186

. Scholars opt for 30 years, the same period was mentioned in working papers

on accounting;

Timing of payment is different.

All these criteria should be reviewed in consideration. The analysis of these characteristics can be

performed on legal documents, but real economic substance of a transaction should be considered as

well. I believe that only real economic relations could evidence what kind of finance takes place.

Based on these characteristics, the arrangements should be considered as debt, if:

1. the borrower is obliged to provide a non-contingency determined payments on a non-

contingency basis;

2. the maturity is determined as 30 years after issuance;

3. the payment is not subordinated to other creditors;

4. the arrangement gives right for primary compensation in case of bankruptcy or liquidation.

5. If one of criteria is not met, the arrangement can be treated as equity.

Based on these characteristic it is possible to identify what type of finance the instrument relates. I

also suppose that the country should consider distinctive features in cooperation taking into account

legal systems, court practice and established business practice.

4.4.2. Allocation of taxing rights – residence/source/ origin

As discussed above taxation of interest and dividends based on source and residence principles may

result in obtaining unfair tax benefits. Moreover, one of the main problematic issues in

interest/dividends taxation is potential reclassification in related jurisdictions. Application of origin

principle is more reasonable as it presumes taxation of income at the place of its generation. This

approach is seemed to be more fair and transparent. Especially, it may allow solve qualification


German Practice“, Bulletin for international taxation, October 2013, p. 308

186 Ibid

conflict if only tax rules of state of origin will apply. Moreover, it will improve tax neutrality and will

not impede competition. Neither domestic not foreign investors will not be discriminated.

4.4.3. The scope – to what transactions harmonized rule should be applied

Developing unified rule it is essential to identified scope of transactions to which this rule will be

applied. Moreover, countries summary shows that legislators limits scope of transactions subject to

review. I suppose that scope should be limited to related parties transactions and transactions that

could be aimed at obtaining tax benefits. Strictly speaking, transactions should not be abusive from

tax point of view. This is quite important as hybrid financial instruments are a tool for tax planning,

including aggressive tax planning and abusive tax practice.

The concept of law abuse is worldwide. There are several EU cases that raise the concept of abuse of

tax law. Firstly, Cadbury Schweppes187

raised the issue that national legislation can restrict EU

freedoms in case of there is artificial arrangements and it is aimed at particular purposes. To identify

such arrangements the subjective, objective and ascertainable evidence must be taken into account.

Another interesting case is Kofoed, where the transaction was structured in way to achieve tax

advantages. Moreover, it was ruled out that tax evasion or tax avoidance were a principal objective

and claimed transaction did not have any commercial reasons188

. At the same time the concept of tax

law abuse has not been unified in direct taxation in European community. Moreover, EU court takes

different approaches and different criteria of abusive tax practice189

. Some authors point out that even

abusive criteria in VAT and direct taxation are different190

.

Non-EU countries also developed concept of abuse of law. Fox example, in Australia, transaction can

be challenged if there is a “scheme,” and transaction provides tax benefit which are dominant purpose

of transaction and would not be taken without “scheme”191

.

At the same time it is obvious that more or less the same factors are taken into consideration in order

to challenge arrangement.

Based on practice of different countries the following criteria of law abuse could be identified:

the arrangement is artificial, that means the transaction does not have commercial

purposes;

the primary aim of arrangement is to obtain tax benefit;

tax benefits could not be achieved without structuring scheme in particular way.

Taking about related parties transactions, I suppose that there is should be financial threshold, and

187 ECJ C-196/04 as of 12.9.2006 - Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd

188 ECJ C-321/05, Hans Markus Kofoed v Skatteministeriet

189 http://delilawblog.wordpress.com/2014/03/13/from-halifax-to-ocean-finance-and-beps-the-role-of-anti-

abuse-principles-and-rules-in-tax-law-part-i/

190 http://delilawblog.wordpress.com/2014/03/13/from-halifax-to-ocean-finance-and-beps-the-role-of-anti-

abuse-principles-and-rules-in-tax-law-part-i/

191 Susan C. Morse and Robert Deutsch; “The development of tax anti-avoidance law in Australia and the

United States”, 2 February 2014, p.8

threshold applied for transfer pricing purposes could also be applicable for these transactions.

4.5. Area for development of alternative solutions

At the same time there are some drawbacks in developing unified approach to hybrid financial

instruments. Thus, all distinctive criteria should be analyzed very properly as a rule should be detailed

and precise. Moreover, developing such rule all potential gaps giving room for different interpretation

should eliminate as possible. For example, maturity of debt, it is quite difficult to identified justifiable

period. I believe that analysis of tax legislation and collaboration between countries will help to it.

Moreover, the scope needs to developed and analyzed properly. Comments on the OECD designed

rule evidences that there are different opinions in this respect.

An unified approach demands harmonization of different legal systems which is generally hard to

achieve. The countries are not willing to change their legal system and adopt unified rules. However,

there are examples of adoption of such rules. Besides, the proposed alternative targets at hybrid

financial instruments only, and harmonization of particular sphere of taxation is more realistic.

At the same time, I would like to point out that these drawbacks are quite general and may be

applicable to any potential solution.

4.6. Short summary of the Chapter 4

The study presents that there are two main solutions to tackle negative effect of hybrid financial

instruments. The one is tie-breaking rule that links treatment of instrument in one jurisdiction with

treatment in another. The rule proposed by the OECD initiatives also considers tax treatment in

another jurisdiction. Moreover, it targets at tax consequences and more inclined at residence taxation.

This approach is in line with OECD principles, but has its disadvantages. In particular, the OECD

solution deals with tax consequences of hybrid mismatches, not solving qualification conflict itself

which is core element of hybrid financial instrument.

The second alternative is harmonized treatment of hybrid financial instruments. The rule is supposed

to be based on distinctive criteria of debt and equity. The rule will be influenced by company law or

accounting treatment of debt and equity, but some decisive characteristics can be useful for designing

rule.

Based on these characteristics, the arrangements between related parties should be considered as debt,

if:


contingency basis;



4. the arrangement gives right for primary compensation in case of bankruptcy or liquidation.

5. If one of criteria is not met, the arrangement can be treated as equity.

6. If there are significant grounds that the arrangement is artificial and aimed at solely gaining

tax benefits, then the arrangement should be reclassified based on its economic substance.

Harmonization rule should be based on origin principle. Allocation of taxing right is key objection of

any solution dealing with hybrid financial instruments. I believe that origin taxation can mitigate and

eliminate a lot of problems associated with this type of finance. It allows providing economic

neutrality as neither domestic nor foreign investors are preferable.

Thus, harmonized approach sets up economic neutrality and eliminate international double taxation.

The rule is based on distinctive characteristics that are determined on variety of financial instruments

and supported by practice. The rule also allows reduction in compliance and administrative costs.

Thereby, the rule is quite sustainable and optimal to tackle negative tax effect.

The one of area for development is its attainability as harmonization is generally hard to be achieved.

However, I believe that harmonization of certain area of tax law is more realistic. Besides, some

countries have already developed and applied more or less similar approach in curbing hybrid

financial instruments negative tax effect. In cooperation of countries an agreement could be reached.

Conclusion

The hybrid financial instruments are frequently used in many jurisdictions by many multinational

companies. This is justified by the financial and commercial point of view. In particular, hybrid

financial instruments are flexible, give possibility to cash flow manipulation and opportunities for tax

planning. However, hybrid financial instruments affect corporate tax and withholding tax which is

considered as tax arbitrage and abusive tax practice. The negative tax effect includes double non-

taxation and double taxation of the remuneration.

The problem arises from qualification conflict. Qualification conflict means different treatment of

debt and equity in different jurisdictions. The qualification conflict takes place not in tax field, but

other areas of law and accounting as well. In addition, each of these disciplines treats hybrid

instruments contradictory. Thus, the qualification conflict is quite complicated.

As hybrid financial instruments are mainly used in cross-boarder transactions, OECD is interested in

regulation of this issue. The OECD issued several documents related to hybrid financial instruments,

such as “Hybrid Mismatch Arrangements, Tax Policy and Compliance Issues”, OECD report

“Addressing Base Erosion and Profit Shifting”, Public discussion draft “Neutralize the effects of

Hybrid Mismatch Arrangements – Recommendations for Domestic Laws” and Public discussion

draft “Neutralize the effects of Hybrid Mismatch Arrangements –Treaty Aspects of the Work on

Action 2 of the BEPS Action Plan”.

The goal of the research was to identify whether the OECD initiatives eliminate negative tax effect of

hybrid financial instruments. The research question was

Can OECD initiatives eliminate or mitigate hybrid financial instruments tax effects? And what can be

proposed as alternative solution?

The OECD initiatives:

In the framework of OECD, the Report was developed. The Report indicates problems, highlights

potential measures and analyzes the rules applied by some countries. Proposed measure and policies

cannot eliminate negative tax effect made by hybrid financial instruments schemes. This document

can be described more as a policy making than rule establishing. However, the policies and analysis

that have been done under this initiative are useful and are a good starting point for further

development which is realized in BEPS plan.

The BEPS plan does not specify any detailed rules or measures that could solve qualification conflict

or provide rule eliminating hybrid instruments' double taxation and non-taxation either. At the same

time, it was not a purpose of the document. The primary aim of the document is to address the

problem. On the other hand, the BEPS plan includes other Actions. As many authors and critics point

out that all these measures should be applied in consideration. All measure, proposed by the BEPS

plan, are aimed at protection of economy and establishment of favorable environment for cross-

boarder investments. It will encourage business activity and provide tax neutrality. However, the

policy and identification of problem is not enough to tackle hybrids abusive tax practice. Negative tax

effect of hybrids is quite obvious and more detailed and specified rule is required.

In the framework of BEPS plan the Draft was published. This Draft is aimed at tax consequences only

and at certain extent eliminates negative tax effect of hybrid financial instruments. The adoption of the

designed rule is achievable, so the rule is attainable.

At the same time it only targets double non taxation and does not consider double taxation issues.

Then, the Draft defines terminology and principles applicable in the framework of hybrid rule.

However, terminology needs to be approved as many critics indicated it. It is noteworthy that goals

and scope are not completely clear, but in order to solve the problem of hybrid finance the rule and

measures should be well structured, formulated and integrated. To solve profit shifting problems

more sophisticated rules and communication between tax authorities are required. Moreover, the

measures adopted under Action 2 should be in compliance with all others Actions, otherwise, hybrid

mismatches rules can lead to non-neutral or unequal treatment. All these factors make the designed

rule not sustainable and sufficient enough.

Another problem is allocation of taxing rights. This is quite essential in cross-boarder content. The

Draft does not specify residence or source approach, but usually OECD applies residence based

principle. In case hybrid finance arrangements residence taxation is not reasonable as mere fact of

residence does not produce income and imposition of taxes at receiver level is not justifiable enough.

In these case I believe that implementation of origin principle could be a better solution as taxation is

justified by the fact place of income generation.

Taking into consideration these arguments I suppose that the designed rule eliminates negative tax

effect of hybrid finance, but it is not sustainable and efficient enough. Moreover, it is not enough fair

and tax neutral and potentially can obstruct business activity.

The alternative option:

As alternative harmonization can be proposed. Such harmonization will be aimed at regulation of

qualification conflict and be based on distinctive criteria. Based on these factors and valid countries’

rules and practice, the arrangements between related parties should be considered as debt finance, if:


contingency basis;



4. the arrangement gives right for primary compensation in case of bankruptcy or liquidation;

5. If one of criteria is not met, the arrangement can be treated as equity finance;

6. If there are significant grounds that the arrangement is artificial and aimed at solely gaining

tax benefits, then the arrangement should be reclassified based on its economic substance.

The same as in case of the designed by OECD rule the allocation of taxing rights should be in line

with origin principle as being more effective. It allows economic neutrality as neither domestic nor

foreign investors are in advantageous position.

I suppose that harmonized rule is more fair and transparent as it deals with the core element of hybrid

mismatches. For the same reasons more tax neutrality is provided as it considers distinctive factors,

not taxation elements. Therefore, the rule is more sustainable and sufficient to tackle negative tax

effect.

The one of potential drawbacks is its attainability as harmonization is generally hard to be achieved.

However, I believe that harmonization of specific area of tax law, such as hybrid financial instruments

regulation, is more realistic. Besides, some countries have already developed and applied more or less

similar approach in curbing hybrid financial instruments negative tax effect.

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NL: SC, 8 Sept. 2006, BNB 2007/104

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ECJ C-196/04 as of 12.9.2006 - Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd

ECJ C-321/05, Hans Markus Kofoed v Skatteministeriet

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