Hybrid Mismatches – UK Proposals for Implementing the BEPS Recommendations

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In Depth

The United Kingdom made its first substantive commitment arising out of the base erosion and profit shifting (BEPS) initiative on 3 December 2014, with the release of a consultation paper on implementing the agreed G20- Organisation for Economic Co-operation and Development (OECD) approach for addressing hybrid mismatch arrangements. This was a response to the initial recommendations of Action 2 of the BEPS project (the G20-OECD Report), which was published in September 2014.

The consultation paper confirms that the UK Government accepts the design principles in the G20-OECD Report and commits itself to implementing them with effect from 1 January 2017. This extended timetable is intended to allow time for consultation on specific aspects of the proposals, particularly in relation to how they affect regulated entities in the financial sector. Final recommendations on this subject are expected to be published by the OECD in September 2015.

Hybrid Mismatches, Entities and Instruments

A “hybrid mismatch” arrangement is defined in the G20-OECD Report as an arrangement designed to exploit asymmetries between different tax jurisdictions through the use of a hybrid entity or a hybrid instrument.

A “hybrid entity” is an entity that is, or may be, treated differently under the rules of two different tax jurisdictions. The most common example is an entity that is treated in one jurisdiction as opaque for tax purposes, i.e., as a taxable person, akin to a company, and in another as being transparent, i.e., akin to a partnership, where the profits of the entity are taxable in the hands of its members. Elections under the “check the box” regulations in the United States can give rise to such a mismatch.

A “hybrid instrument” is one characterised differently by two tax jurisdictions, for example, as debt in one jurisdiction and equity in other.

The G20-OECD proposals are directed at structures involving hybrid entities or instruments that give rise to either a deduction in two jurisdictions (a DD outcome) or a deduction in one jurisdiction with no inclusion of the corresponding receipt in taxable income, whether in the same or another jurisdiction (a D/NI outcome).

The UK Context

The United Kingdom has for some time had a number of rules aimed at preventing companies from benefiting from hybrid mismatches. As long ago as 1987, dual resident investment companies were prevented from surrendering their losses by way of group relief, in order to stop the group from obtaining a deduction for the same expense in two jurisdictions. Similar restrictions also exist in relation to losses attributable to permanent establishments, for similar reasons.

In 2005, the “international arbitrage” rules were introduced to deny deductions arising from hybrid arrangements where one of the main purposes of the relevant arrangement was the avoidance of UK tax.

Finally, in 2009, the new corporation tax exemption for dividends from foreign companies was conditioned on the dividend payments not giving rise to a deduction in the payor jurisdiction, nor being part of wider arrangements giving rise to such a deduction.

The implementation of the G20-OECD proposals will effectively mean that Her Majesty’s Revenue and Customs will no longer need to establish that a hybrid arrangement had the purpose of avoiding UK tax before it can counteract the benefit of the arrangement. The proposals instead provide a mechanical set of rules determining which jurisdiction can counteract the benefit of the hybrid arrangement. The proposals would also make some minor changes to the rules governing dual resident companies.

The Principal Proposals

The G20-OECD Report proposes a joined-up approach to addressing hybrid mismatch arrangements, involving a hierarchy of rules.

At its simplest, a hybrid mismatch will normally involve two jurisdictions. The primary rule (Rule A) will determine which of the two jurisdictions may disallow the deduction. If that jurisdiction has not introduced, or does not implement, hybrid mismatch rules, the other jurisdiction will be able to invoke the secondary defensive rule (Rule B) to counteract the mismatch by denying the deduction or tax the corresponding receipt as the case may be.

This will have the following effects:

  • Where a UK entity makes a payment as part of a hybrid arrangement, Rule A will deny a deduction to the extent that it gives rise to a D/NI outcome.
  • Where a UK entity receives a payment as part of a hybrid arrangement with a D/NI outcome, Rule B will operate to tax the payment in the United Kingdom if the jurisdiction of the payor does not apply Rule A.
  • Where a UK entity is an investor in a hybrid entity that is treated as transparent for UK tax purposes, Rule A will deny a deduction for payments that gives rise to a DD outcome.
  • Where a UK entity is a hybrid entity making a payment which gives rise to a DD outcome, Rule B will deny a deduction if the investor jurisdiction does not apply Rule A.

Where a hybrid mismatch arises by virtue of both a hybrid instrument and a hybrid entity, the rules will counteract the hybrid instrument mismatch first.

Other Proposals

The G20-OECD Report further recommends the introduction of rules to address “reverse hybrids”, that is, entities regarded as transparent where they are located and opaque at investor level. The Government has concluded that this is only potentially relevant to limited liability partnerships (LLPs), and will implement the proposal by treating LLPs that are reverse hybrids as being companies and therefore subject to corporation tax.

The existing loss relief restrictions for dual resident investment companies will be strengthened. In future, all dual resident companies (not simply investment companies) will be denied all deductions, unless they are set against income that is subject to dual inclusion or the deductions are permitted under the terms of a tax treaty competent authority agreement.

The UK Government has also indicated that it prefers to determine company residence for treaty purposes through competent authority agreement, and that it will continue to negotiate treaty tie-breaker provisions in that manner, as it has done in a number of recent treaties.

The G20-OECD Report also proposes the denial of any exemption for dividends giving rise to a deduction. The government has concluded that its existing rules already provide sufficient safeguards and it therefore does not propose to make any further amendments to the scope of the tax exemption for dividends.

It is worth noting that the rules will not apply simply because a jurisdiction provides a notional interest deduction for equity capital (as is the case in Belgium or Italy). The rules will also not counteract tax rate arbitrage: for example, where a payment of interest by a UK company results in a receipt that is taxed at a lower rate than the deduction is relieved in the United Kingdom.


It is generally accepted that these proposals are most likely to affect group financing arrangements.

A great deal of US investment into the United Kingdom has historically been structured through the use of hybrids. At its simplest, this has involved the use of US “check the box” rules to ensure a D/NI outcome on intra-group loans from the United States to the United Kingdom. More complex structures have involved the use of hybrid instruments in intermediate jurisdictions, such as Luxembourg, to ensure an interest deduction in the United Kingdom and an equity return in the United States, which will result in a D/NI return to the extent that the US tax liability is reduced by foreign tax credits.

All planning of this nature is likely to be vulnerable to counteraction if these rules are introduced, and groups with existing structures should start to consider whether or not they will need to be unwound or restructured before the new rules start to bite.


The hybrid mismatch proposals have been released alongside rather more immediate and Draconian proposals to tax profits diverted away from the United Kingdom (see “The UK’s New Diverted Profits Tax” On the Subject). Together, they represent a fundamental change to the tax landscape for US and other foreign businesses with investments and customer bases in the United Kingdom. All such multinationals should review their structures accordingly.