Item Illustration : BEPS Action 2: Hybrid mismatch arrangements – tackling the mismatch rules

BEPS Action 2: Hybrid mismatch arrangements – tackling the mismatch rules

Viraj Mehta – Bourner Bullock – United Kingdom

Share this article

BEPS Action 2: Hybrid mismatch arrangements – tackling the mismatch rules

Viraj Mehta – Bourner Bullock – United Kingdom

Share this article

What Mismatches ?

Hybrid mismatch arises because companies take advantage of hybrid entities or the instrument because they are viewed differently by the two respective jurisdictions.  An entity may be considered a company by one jurisdiction and a partnership by the other, or an entity by one jurisdiction and a branch by the other; or a financial instrument as debt by one jurisdiction and equity by the other.


As a result, it has been possible for losses (including interest) to be deducted twice; or for payments to be deducted without a corresponding tax on the counterparty’s income. Examples of this are the US check the box regulations, enabling a company to be treated as transparent and a partnership to be treated as opaque; and the German regulations enabling a partnership to be treated as opaque.


Example of deduction/no income 

To acquire a UK subsidiary (UKSub), a US company (USCo) could incorporate a UK holding company (UKH). UKH would borrow funds from USCo to acquire UKSub. Under US IRS Regulations, USCo is entitled to elect for UKH to constitute a ‘disregarded entity’ (basically its branch) for US tax purposes (Check the Box rules).

This election had no effect in the UK where UKH is regarded as a company able to surrender the interest on its borrowings from USCo against the profits of UKSub. However, in the USA, USCo is regarded as receiving the interest from its branch (UKH). For US tax purposes, the interest is therefore ignored as arising within the same entity, namely USCo. In this way, the hybrid nature of UKH allowed for the interest to be deducted in the UK without being taxed in the USA.


BEPS anti hybrid rules in action

In 2023, the UK Upper Tribunal dismissed an appeal by JTI Acquisitions (2011) v HMRC [2023]UK194


The case involves a UK acquisition financing structure which was set up by a US company, Joy Global Inc, to acquire another US company, LeTourneau Technologies Inc.  A UK company, JTI Acquisition Co (2011) Ltd (JTI UK), was incorporated to fund the $1.1bn acquisition of LeTourneau in the US by way of a loan of $550m and share capital.

The key to the structure was the establishment of 3 companies, one in the US which reassigned a $550 million loan note to a Cayman Island company, which loaned this to the UK company JTI UK.  These three entities were effectively treated as a single entity for US tax purposes. This meant there was no net income for US tax purposes as the finance costs of JTI UK equalled the finance income in the US lender. Therefore, there was a one-sided deduction in the UK which was intended to be group relieved in the UK Group. Also, as JTI UK was buying the target company, there would be an exemption from dividends and CGT on future sale under UK tax rules.

The UK Courts did not allow the deduction of interest deeming it to be for an unallowable purpose as there was no reason for having a UK company to acquire the target company. The 2016 anti-Hybrid rules would have also disallowed this transaction.


How is this type of mismatch being tackled?

The UK

The UK has broadly applied the Action 2 recommendations in Finance Act 2016 through its hybrid mismatch rules.  The rules are complex and apply to a wide range of structures and are not confined to related party transactions. As a result, the UK is now able to deny deductibility of the trading loss and interest payments.

The EU

Within the EU, ATAD has made it mandatory for all EU jurisdictions to implement hybrid mismatch legislation broadly in accordance with Action 2. Jurisdictions are also amending their entity classification rules to prevent hybrid mismatches.

For example, Germany offers a ‘check the box’ election for partnerships (KG or OHG) by which an election can be made to treat them as a corporation. To prevent a hybrid mismatch, the election is conditional on a foreign partnership being similarly treated as a corporation in its country of management. The Netherlands has changed its laws so that a CV will no longer be subject to corporate income tax and will therefore be treated as transparent.

Non-EU jurisdictions

Among the selected jurisdictions and outside the EU, Australia, Japan and the US have also enacted hybrid mismatch rules.