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Policy Proposals  Business Law Comments on the Public Discussion Draft on BEPS Action 2 (Neutralise the Effects of Hybrid Mismatch Arrangements)

April 28, 2014

Committee on Fiscal Affairs
Organisation for Economic Co-operation and Development

Comments on the Public Discussion Draft on BEPS Action 2
(Neutralise the Effects of Hybrid Mismatch Arrangements)

Keidanren hereby submits its comments on the Public Discussion Draft "BEPS Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements" published by the OECD on March 19, 2014.

  1. Abusive arrangements that exploit differences among countries in the tax treatment of entities and financial instruments are one of the reasons why base erosion and profit shifting (BEPS) has become a concern of the international community. Neutralizing the effects of such abusive hybrid arrangements is of paramount importance to preventing the erosion of the tax base of each country and ensuring a level playing field for companies. Keidanren supports the OECD's initiatives to establish concrete rules based on BEPS Action 2.

  2. When creating concrete rules for preventing tax avoidance, due consideration needs to be given to ensure that the new rules will neither hamper normal business activities nor impose excessive administrative burdens on taxpayers and tax authorities, as pointed out in our comments concerning the public discussion drafts on other BEPS Actions.

  3. From that perspective, we believe that the contents of this Public Discussion Draft require further examinations on whether there is a consistency between the ends and the means, as is the case with the rules already proposed based on other Actions.

  4. As a measure of neutralizing the effects of hybrid mismatch arrangements, the Public Discussion Draft proposes linking rules (hybrid mismatch rules) that link the domestic tax treatment to the tax treatment in another country.

  5. The rules are aimed at eliminating the mismatches arising from the existing tax systems, not questioning the appropriateness of differences in the tax treatment of entities and financial instruments under the laws of individual countries. As such, they will apply comprehensively and automatically following the procedure.

  6. When applying linking rules, no consideration will be given to such matters as where and to what degree base erosion took place and how tax revenue should be recovered. The primary purpose lies in eliminating the mismatches and thereby discouraging taxpayers from avoiding taxes.

  7. We consider this approach, though theoretically clear, to be excessive as a measure of preventing limited abusive companies from avoiding tax. A particular concern is that, in many countries operating a self-assessment system for corporation tax, the taxpayers will have to ascertain the tax treatment of individual arrangements in other countries by themselves. We are concerned that such task may impose enormous administrative burdens and costs on taxpayers.

  8. Taxpayers need to establish, to the satisfaction of the tax administration, that the deduction for the hybrid payment cannot be set-off against the income of any person under the laws of the other jurisdiction, in order to prevent stranded losses (italics added)(Page 51). Such requirement will also result in increased administrative burdens.

  9. Another concern is that it will be up to each country to decide whether or not to incorporate hybrid mismatch rules into domestic law and, if deciding to do so, how to codify the rules into law. This means that if intergovernmental cooperation does not work, arrangements may be subjected to multiple tax systems and regulations, leading to the greater risk of double taxation. The mission the OECD is expected to accomplish in the field of international taxation is to eliminate double taxation. Close attention should be paid to ensure that too much focus on preventing double non-taxation will not result in increased double taxation.

  10. The Public Discussion Draft proposes design principles for hybrid mismatch rules, such as avoiding double taxation through rule coordination, and being workable for taxpayers and keeping compliance costs to a minimum (paragraph 27). It is questionable, however, whether the proposals at this stage satisfy these principles. We request that the final report on BEPS Action 2 recommend measures more specifically targeting abusive arrangements. Linking rules should meet at least the following five conditions:

Adopt a bottom-up approach

  1. As for hybrid financial instruments, a category of hybrid mismatch arrangements, the Public Discussion Draft proposes that no dividend exemption be granted to the payee if the payment is deductible by the payer.

  2. Additionally, it is proposed that the scope of the hybrid financial instruments unconnected to a dividend exemption be stipulated by domestic law, using either a bottom-up or top-down approach (paragraph 116 and thereafter).

  3. In this regard, we believe that the application of the bottom-up approach should be mandatory in light of the hybrid mismatch rules' primary purpose of preventing abusive arrangements and from the perspective of minimizing administrative burdens on taxpayers.

  4. The top-down approach cannot possibly be accepted even if some carve-outs are permitted, because the approach encompasses all hybrid financial instruments including unintended ones. While some may argue that the bottom-up approach is not a comprehensive solution, we consider overly high compliance costs associated with the top-down approach to be far more problematic.

  5. With regard to the denial of the dividend exemption, attention should be paid to the fact that, even if a payment is deductible by the payer, a deduction of the entire amount may not necessarily be allowed. This gives rise to a number of technical issues to be addressed concerning with what level of detail the denial of the dividend exemption should be made and in what way double taxation should be eliminated in the case of the dividend exemption being denied. This is same for other financial instruments.

Develop a practicable definition of related parties

  1. The Public Discussion Draft states that, regardless of taking a bottom-up or top-down approach, hybrid mismatch rules should apply to financial instruments that are held by related parties or part of structured arrangements (paragraph 121). However, "a 10% or greater investment" proposed as the definition of related parties is broad.

  2. In the first place, countries need to assess how serious the BEPS risk could be in the case of such a small shareholding. What we have to do is to specify abusive transactions that give rise to BPES and focus on eliminating them.

  3. As the rationale for the 10% threshold, the Public Discussion Draft states that "companies, funds and other entities and arrangements can generally be expected to take into account the position of their non-portfolio investors (i.e. 10% or greater) when entering into their arrangements with those investors," and that "similarly any non-portfolio investor should, in general, have a sufficient economic stake in the issuer to obtain the information necessary to comply with the hybrid mismatch rule" (paragraph 127). Yet, it would not be easy for a taxpayer with only a 10% investment in another entity to ascertain the tax treatment in the country of the entity.

  4. If an investee is a wholly owned subsidiary or other entity over which the taxpayer has strong control, the taxpayer might be able to communicate with the investee's finance department that has a wealth of knowledge about the country's tax laws. Otherwise, ascertaining the tax treatment in that country would require locating and hiring a local tax adviser, incurring substantial time and costs. On top of that, the country's tax authority might take a different view from that of the investee or the local tax adviser.

  5. When specifying the definition of related parties in domestic law, each government will inevitably consider consistency with the existing domestic tax rules, such as those on dividend exemption, transfer pricing taxation and controlled foreign companies (CFCs). In the course of such process, whether or not the 10% threshold is appropriate will likely be discussed in each country. One of the design principles for hybrid mismatch rules is to minimize the disruption to existing domestic law. In accordance with this principle, careful discussions should be held on the definition of related parties, taking into account the circumstances of each country.

  6. In the light of actual practices, we consider the appropriate definition of related parties of an entity to be consolidated subsidiaries for accounting purposes.

  7. Whereas the Public Discussion Draft proposes a different scope for each category of hybrid mismatch arrangements, unnecessary complications of the system must be avoided. We believe that hybrid mismatch rules should apply only to arrangements entered into between related parties in all the categories including hybrid financial instruments, except for structured arrangements.

  8. In connection with this point, hybrid mismatch rules should not apply to widely held instruments and traded instruments, such as listed or publicly offered products. We must avoid applying the rules in a way that discourages investors from investing in financial instruments.

  9. The burden of ascertaining the tax treatment in another country should not be imposed solely on taxpayers; government should also be required to establish regulations on prior confirmation and ruling. We ask the OECD to publish the list of jurisdictions that have adopted hybrid mismatch rules and provide an outline of each of these jurisdictions' hybrid mismatch rules.

  10. As for structured arrangements, it is imperative to specify requirements for the application of hybrid mismatch rules as suggested in paragraph 131, from the perspective of ensuring predictability for taxpayers.

Take a flexible stance toward regulated industries

  1. Some financial institutions issue, for regulatory reasons, securities that may outwardly correspond to hybrid financial instruments. The uniform application of hybrid mismatch rules may therefore hinder the sound development of the financial industry.

  2. For example, in capital-raising arrangements to comply with the minimum capital requirements under Basel III, some banks issue securities that are treated as subordinated bonds by the banks themselves but have the characteristics of preferred shares for final investors. Although those securities may correspond to hybrid financial instruments, it is not reasonable to apply hybrid mismatch rules to capital-raising schemes undertaken to meet regulatory requirements. Such securities issued for regulatory reasons should be treated flexibly, including exemption from the rules.

  3. It can be said that the same problem may occur for industries other than in the financial sector, for example if a new regulation is introduced to those industries and companies have to observe them.

Ensure consistency with other BEPS Actions

  1. BEPS Action 2 states that "this work will be co-ordinated with the work on interest expense deduction limitations, the work on CFC rules, and the work on treaty shopping." With regard to treaty shopping, the Public Discussion Draft on Action 6 has proposed a tie-breaker rule for determining the treaty residence of dual-resident persons (revision to Article 4, paragraph 3 of the OECD Model Tax Convention). Also, this Public Discussion Draft on Action 2 proposes the addition of paragraph 2 to Article 1 of the Model Tax Convention to ensure that fiscally transparent entities are not used to obtain the benefits of treaties unduly. However, as for CFC rules and interest expense deduction limitations, details of proposals have not been made public, partly because deadlines for Actions 3 and 4 are next year.

  2. Hybrid mismatch rules, which are designed primarily to address deduction/no-inclusion structures, are closely linked to Action 4 for payer issues and to Action 3 for payee issues. In the BEPS Action Plan, too, Actions 2, 3, and 4 are under the same section entitled "Establishing international coherence of corporate income taxation." In view of these, it is more appropriate that Action 2 proposals and specific changes to domestic laws be examined after concrete proposals for all these Actions have been published. Coordination with Action 14 (Dispute resolution mechanism) is also indispensable so as to avoid double taxation. Countries should not hastily implement the recommendations under Action 2 alone.

Reconsider the treatment of imported mismatches

  1. We find it unreasonable to stipulate that a taxpayer who is not a party to hybrid financial instruments, entity payments, and other arrangements be denied a deduction for the payment on the grounds that the counterparty's country does not apply hybrid mismatch rules. Such rule will undermine stable administration and result in increased uncertainty. Imported mismatches (paragraph 206 and thereafter) should not be subject to hybrid mismatch rules except when they arise from structured arrangements.

Subcommittee on Taxation

Business Law