Hybrid instrument update (2023)

Joe Sullivan

Covington & Burling, Washington, DC

jsullivan@cov.com

Report on the session of the Taxation Section at the 12th Annual London Finance and Capital Markets Conference in London

Monday 16 January 2023

Session Chair

Paul Carman Chapman & Cutler, Chicago

Speakers

Michaela Engel Noerr, Munich

Antti Lehtimaja Krogerus, Helsinki

Matthew Mortimer Mayer Brown, London

Rebeca Rodriguez Martínez Cuatrecasas, Madrid

Cesare Silvani Maisto e Associati, Milan

Introduction

Paul Carman introduced the speakers and explained that the panel would provide an update on the treatment of hybrid instruments. Carman summarised the various discussion topics of relevance to the panel.

Distribution of dividends to non-European Union funds

Rebeca Rodriguez Martinez began by discussing issues relating to the distribution of dividends to non-EU funds, with a focus on Anti-Tax Avoidance Directive (ATAD) II and specific Spanish anti-hybrid rules. She introduced the ‘primary’ anti-hybrid instrument rule under either regime, under which a hybrid mismatch results due to a different classification between two or more countries with respect to an instrument, entity or permanent establishment (PE), and any resulting deduction is directly denied in Spain. There are similar methods in certain jurisdictions to make entities appear tax transparent, most notably using the United States check-the-box election. This creates flexibility for taxpayers and tax planning opportunities, including with respect to financing structures. Martinez noted that, from a Spanish perspective, to prevent mismatches, the classification in the location of an entity’s incorporation generally controls the situation. Yet, although the Spanish rules generally prevent mismatches, some may still result. When a mismatch occurs, the Spanish anti-hybrid rules require that a ‘control situation’ or ‘structured mechanism’ be present. The Spanish rules define control broadly and include situations in which ‘joint actions’ or ‘significant influence’ are present that suggest that there is coordination among parties that are not under common ownership. Martinez mentioned that funds with minority common ownership but the same managers (or, less commonly, the same general partners) may fall within these rules, and that other unusual or unintended results may occur. Base erosion and profit shifting (BEPS) Action 2 defines relatedness and concerted action or joint management, including when the existence of an arrangement has a substantial effect on the value or control of voting rights or interests. Martinez emphasised that the best practice for managing these rules is to look not only at the direct satisfaction of the Organisation for Economic Co-operation and Development (OECD) guidelines but also at the rest of the substance of the arrangement, including side letters and other indicia of concerted action. Another definition to consult is that of ‘significant influence’, which is presumed to exist when one has the power to intervene or influence an arrangement, but does not control the entity. Martinez discussed specific examples included in the BEPS Action 2 commentary that can help to determine when control may exist.

Cesare Silvani discussed Italy’s approach to distributions to non-EU funds. He noted that Italy had to change its legislation in 2021. Before 2021, Italy’s domestic law imposed withholding taxes on dividends paid to foreign funds and taxed capital gains realised by foreign funds on substantial participation in Italian companies, but did not tax Italian funds. The EU determined that this was discriminatory and violated the free movement of capital, so Italy updated its rules granting an exemption to EU funds. Non-EU funds are still exposed to Italian source taxation on dividends and capital gains (except for capital gains on portfolio participation held by non-EU ‘white list’ funds). This persisting source taxation represents a breach of EU law by Italy, and the Italian Supreme Court endorsed this view in a series of decisions issued in 2022.

Anti-hybrid and pre-existing avoidance rules

Michaela Engel stated that, unlike Italy, Germany decided to go in the opposite direction with new legislation and now taxes German investment funds on domestic dividends (rather than exempting foreign funds). Under German law, a participation exemption additionally only applies if at least ten per cent of the shares in the corporation are held.

Engel started her discussion with an example of the German anti-hybrid rules and showed an illustration of a common hybrid structure with a foreign company on top and a German Gesellschaft mit beschränkter Haftung (GmbH) as its 100 per cent subsidiary. Interest is paid pursuant to a hybrid instrument, with a deduction in Germany and a non-inclusion in the foreign jurisdiction. Germany was very slow to police this type of transaction. Thus, German rules were developed to cover mismatches of either instrument qualification or asset attribution resulting in income either not subject to taxation or subject to tax at a lower rate at the recipient, though there is an exception under which the mismatch is only temporary, and the terms and conditions are at arm’s length. The rules also apply to any deduction/no inclusion scenarios with a mismatch in the qualification of the entities involved and any double deduction scenarios, and are not limited to financing transactions. Engel listed a number of transactions that the Germany anti-hybrid rules cover.

Engel explained that imported mismatches are specifically covered under the German rules, and such rules are structured broadly to include, for example, back-to-back structures and expenses within a structured contractual arrangement where it would be reasonable to expect that the parties to a transaction expected the resulting tax benefit. Engel emphasised that clients should look closely at their acquired structures for any imported mismatches they may not be aware of. Engel presented an example of a Dutch ownership group owning a German hybrid entity, in which a loan within the Dutch group is treated as made within the Dutch group, giving rise to interest income and a deduction in the Netherlands and a deduction in Germany due to the German entity’s hybrid treatment. Although at least two German rules could apply, is it likely that the rule against ‘double deductions’ would apply to deny the deduction for German purposes.

Engel explained that the hybrid mismatch rules apply to expenses made after 2019 between related parties, that is, where there is direct or indirect ownership or profit interest between the parties of at least 25 per cent, or alternatively where parties are acting in concert, a PE situation or structured arrangement situations. Engel also discussed other rules which: (1) prevent non-taxable contributions to capital if a deduction is made abroad; or (2) allow the participation exemption only where the dividend is not deductible by the payor. Engel also discussed various examples under new reverse hybrid rules that came as a result of ATAD II.

EU debt-equity bias reduction allowance (DEBRA): proposed directive and interaction with anti-hybrid rules

Antti Lehtimaja discussed the EU DEBRA rules, which he stated are designed to provide a better business tax system in the EU and avoid bias caused by the preference for debt in most tax systems. DEBRA would provide a notional interest deduction for equity increase resulting from capital injections or profits, following attempts to do this in other jurisdictions, including EU states such as Belgium. Lehtimaja discussed the specific calculation of the DEBRA notional interest deduction and noted that it is limited to 30 per cent of a taxpayer’s earnings before interest, tax, depreciation and amortisation (EBITDA). DEBRA rules are proposed to apply as of 2024, but Lehtimaja expressed scepticism about whether this would occur given the current priority of other initiatives, including Pillar 2. Lehtimaja compared the DEBRA rules to the ATAD II anti-hybrid rules discussed earlier, noting that it is not clear whether the ATAD II rules could apply in certain circumstances to deny a DEBRA allowance, where the DEBRA allowance could arguably give rise to a hybrid mismatch situation. However, because a DEBRA allowance is notional only and not linked to payments, Lehtimaja said that there may be grounds to argue that a DEBRA allowance should not be subject to ATAD rules, which are designed to apply only to payments. This interpretation is also supported by the BEPS Action 2 report.

Silvani added that Italy has had a notional interest deduction in place since 2011, and that Italy’s regime is similar to DEBRA, although there are differences. Silvani stated that Italy’s rules are likely to be more generous that the DEBRA rules, and stated that under DEBRA as proposed, countries with existing notional interest deduction regimes may defer adopting the OECD rules in full for up to ten years. Silvani noted that the current Italian regime may be incompatible with the US section 267A rules, which may be seen as a hybrid deduction triggering the imported mismatch rules. Silvani stated that he is aware of clients that have had deductions disallowed for these reasons. He added that this will be an issue for any country with a notional interest deduction, and that if DEBRA is adopted, every country in the EU may have these issues.

Carman added that the US rules are important here, and that section 267A denies benefits in situations like this: where there is a real deduction for interest in the US and a notional interest deduction in Italy. According to Carman, this is a problem ‘straight from the regs’ in the US and has practical implications for Italian structures.

Lehtimaja added some additional thoughts on Finland’s taxation of hybrid instruments and other anti-hybrid rules. Lehtimaja stated that Finland has had a general anti-avoidance rule (GAAR) for many years, but has not applied it in the anti-hybrid context. Finland has also traditionally had a liberal practice of allowing interest deductions. Now, Finland’s anti-hybrid rules generally follow the ATAD II requirements.

Recent changes to the United Kingdom’s anti-hybrid rules

Matthew Mortimer discussed recent changes to the UK’s anti-hybrid rules. The UK has had anti-hybrid rules since 2017, but Mortimer explained that the rules are known for their overreach, going beyond the BEPS Action 2 recommendations in certain respects. The hybrid financial instrument section of the rules generally applies, outside of structured arrangements, where parties are related and if there is an impermissible deduction/non-inclusion of the income mismatch. However, Mortimer noted that recent changes, predominantly enacted in the Finance Act 2021, have narrowed the rules somewhat. For example, as a result of those changes, ordinary lenders with a five per cent or less interest in a borrower company are not usually treated as acting together with other lenders in a way that might cause the lender and borrower to be ‘related’. The Finance Act 2021 has also provided important carve-outs from the rules for certain de minimis investors in transparent investment funds (broadly, investors with less than ten per cent interest in the fund) and for so-called ‘qualifying institutional investors’, such as certain types of pension funds, sovereign wealth funds and widely held investment funds. Mortimer additionally noted the important changes that the Finance Act 2021 has made to imported mismatch rules within the UK’s wider anti-hybrid rules. In particular, as a result of those changes, the rules no longer apply if the requisite overseas mismatch arises in a jurisdiction that is ‘OECD mismatch compliant’, which is broadly the case if the jurisdiction has implemented anti-hybrid rules based on the BEPS Action 2 recommendations. Finally, Mortimer explained that important changes were also made in the Finance Act 2021 regarding how the UK’s anti-hybrid rules apply to debt releases: it is now easier, broadly speaking, for distressed and other borrowers to escape the application of those rules in such circumstances, but not all recent changes had been favourable for taxpayers. In particular, Mortimer explained that, in light of recent legislative changes and additions to the published guidance of the UK tax authorities, the inclusion of income within the US global intangible low-taxed income (GILTI) regime will not prevent such income from generating an impermissible mismatch that can be counteracted under the UK’s anti-hybrid rules, which may create double taxation issues.