Neutralizing the effects of Hybrid Mismatch Arrangements

SUITS THE C-SUITE By Faustina Victoria E. Ochoa-Sarmiento

Business World (01/26/2015 – p.S1/4)

IN THIS second installment of the series on Base Erosion and Profit Shifting (BEPS) 2014 deliverables, we will discuss the recommendations of the Organization for Economic Co-operation and Development (OECD) on how to neutralize the effects of Hybrid Mismatch Arrangements.

A Hybrid Mismatch Arrangement refers to an arrangement whereby companies, or groups of companies, operating in different jurisdictions, make use of the differences in the tax treatment of an instrument (hybrid instrument) or an entity (hybrid entity) in these jurisdictions, to arrive at an overall reduction or elimination of the tax burden. These companies, which may have different entities set up in various taxing jurisdictions, could make use of the different tax rules in each jurisdiction to match, or perhaps more correctly, mismatch income payments to claim more deductions and pay lower taxes. An income payment under a Hybrid Mismatch Arrangement results in a Double Deduction (DD) outcome when the payment is treated as a deductible expense in more than one taxing jurisdiction. It can also result in a Deductible and Not Included (D/NI) outcome when the income payment is treated as a deductible expense of the income payor, but not included in the ordinary income of the income payee or any related investor of the payee.

Hybrid Mismatch Arrangements are generally frowned upon when the parties to the mismatch are members of the same business group or controlled by the same entity, on the assumption that a controlling entity may structure a transaction in such a way that the jurisdiction of the parties thereto or the terms of the instrument result in BEPS.

In focusing on Hybrid Mismatch Arrangements, the OECD’s goal is to arrive at a consistent treatment of income payments for all parties to a transaction, eliminating DD and D/NI outcomes. Although the BEPS Report does not aim to address all kinds of possible hybrid instruments as this may prove to be impossible in practice, the model provisions in the Report focus on those hybrid mismatches which are of most concern to jurisdictions. The Report proposes the denial of deductions when necessary, and a linking rule which will align the tax outcomes of an income payment.

More specifically, these recommendations include the following:


This rule may apply to payments made under a financial instrument that is treated differently by the taxing jurisdictions of the parties to the instrument. The Hybrid Financial Instrument Rule aims to neutralize the mismatch to the extent that the payment gives rise to a D/NI outcome. Here, it is recommended that the taxing jurisdiction of the income payor deny the deduction which will result in a D/NI outcome. If the payor jurisdiction refuses to do so, the defensive rule is to require that the payment be included in the payee’s ordinary income.

Recommendations for the tax treatment of financial instruments under the rule include the denial of dividend exemption for the income payee when the dividends are exempted from tax in the payor’s jurisdiction. Another recommendation is to limit credits for taxes withheld at source only in proportion to the net taxable income of the payee.


A disregarded payment is one that is not taxed in the jurisdiction of the income payee. If the income payment is deductible in the taxing jurisdiction of the payor, this arrangement will give rise to a D/NI outcome. The recommendation is to deny the deduction in the taxing jurisdiction of the payor. Failing such denial, the income payment should be included in the ordinary income of the payee.


A reverse hybrid entity is one that is treated as a separate entity by a related investor but is considered as a transparent entity in the establishment jurisdiction. Hence, payments made to the reverse hybrid entity by its related investor will be deductible by the related investor but not subject to tax in the taxing jurisdiction of the reverse hybrid, resulting in a D/NI outcome. The recommendation is to deny the deduction in the taxing jurisdiction of the payor.

In terms of the tax treatment of reverse hybrids and imported mismatches, the report suggests that jurisdictions introduce controlled foreign corporation (CFC) rules to prevent D/NI outcomes, limit tax transparency for non-resident investors, and improve the manner of information reporting for intermediaries.


This applies to payments made to a hybrid entity which gives rise to a DD outcome. The recommended course of action is to deny the deduction in the jurisdiction of the payee, failing which the deduction should be denied in the jurisdiction of the payor.


This rule shall apply when the income payor is a tax resident of two jurisdictions and the income payment is deductible in both, giving rise to a DD outcome. The recommendation is for each jurisdiction to deny the deduction to the extent that it gives rise to a DD outcome.


In an imported mismatch arrangement, a hybrid mismatch is created in one jurisdiction and the effect of that mismatch is imported into the payor jurisdiction through the offsetting of the deduction under that hybrid mismatch arrangement against the income received. The recommendation is to deny the deduction to the extent that the hybrid deduction is set-off against the payment in the payee jurisdiction.

The Report emphasizes that all the recommendations are intended to operate as a comprehensive and coordinated set of rules to neutralize mismatches arising from transactions of hybrid entities or from the use of hybrid instruments. It is intended for the rules to apply automatically, minimize the disruption to existing domestic law, be clear and transparent in their operation, provide sufficient flexibility to be incorporated into local laws, be workable for taxpayers with minimum compliance costs, and minimize any administrative burden on tax authorities.

It is also recommended that jurisdictions incorporate into their domestic laws definitions which are consistent with those in the Action Plan. Moreover, the output from this Action should be implemented in coordination with the output from other Actions to arrive at a comprehensive measure against BEPS.

The Report also discusses possible issues arising from the adoption of the recommendations. More specifically, these involve dealing with dual-resident entities to prevent them from unduly availing themselves of treaty benefits, treatment of transparent entities, and how the recommendations stand in relation to the OECD Model Tax Convention. The Report proposes changes to the OECD Model Tax Convention to address these issues, but these recommendations are not final and still pose concerns, especially with regard to those jurisdictions which have not entered into tax treaties.

Implementing the recommendations on Hybrid Mismatch Arrangements will entail much work and time, as these may involve changes in both local legislation and our treaty obligations. Nevertheless, as more and more Philippine companies do business abroad, these recommendations need to studied and analyzed this early by the company’s executives.

Faustina Victoria E. Ochoa-Sarmiento is a Tax Director of SGV & Co.