EU Council reaches ATAD II compromise to close hybrid mismatch tax loophole

by Davide Anghileri

The EU Council on 21 February reached agreement on a Council directive aimed at stopping multinationals from lowering their overall tax liability by taking advantage of differences in tax laws, called hybrid mismatches, involving non-EU countries (ATAD II).

“The EU is at the forefront of the fight against tax avoidance. We want to ensure coherent implementation in EU law of the OECD’s [base erosion profit shifting (BEPS)] action plan,” Minister for Finance of Malta and President of the Council Edward Scicluna, said, announcing the agreement.

The directive, which would amend directive (EU) 2016/1164, is the latest of a number of EU measures designed to prevent tax avoidance by large multinationals. It was part of a package of corporate taxation proposals presented by the EU Commission in October 2016 to implement the 2015 OECD/G20 BEPS recommendations.

Its goal is to counteract hybrid mismatch arrangements in a holistic and comprehensive way at EU level, to avoid inefficiencies and distortions caused by the interaction of different national tax measures.

It is very difficult for a Member State to reach this result acting individually.

Intra-EU hybrid mismatches were addressed in the Anti-Tax Avoidance Directive, adopted in July 2016 (ATAD I).

Hybrid regulatory capital carve out

The Council agreed to compromise on hybrid regulatory capital. The proposal sets out a carve-out from the rules for the banking sector in connection with consolidated groups that issue financial instruments for the purposes of meeting loss-absorbing capacity requirements.

The ATAD II compromise specifies that payments made as part of a structured arrangement will give rise to hybrid mismatches and that also intermediate payments will be targeted, not only those made to the ultimate parent.

Any mismatch in tax outcomes should only result in a single deduction under the structure, the proposal points out.

The carve-out will be limited in time under a sunset clause and the Commission will be tasked with evaluating the application of the directive and presenting a report assessing the consequences.

Financial traders

The Council also agreed that payments made by financial traders will not give rise to hybrid mismatches, provided some conditions are met.

If a payer jurisdiction requires a financial trader to include in income all amounts received in relation to the transferred financial instrument, a hybrid will not arise, the directive states.

Hence, a hybrid mismatch will only arise to the extent that the payer jurisdiction allows the deduction to be set-off against an amount that is not dual-inclusion income.

A mismatch outcome arising from a payment by a financial trader can be considered as a hybrid only if it arises between associated enterprises, between a taxpayer and an associated enterprise, between the head office and permanent establishment, between two or more permanent establishments of the same entity, or under a structured arrangement.

This approach is more in line with the OECD BEPS Report on Action 2, which treats financial traders as outside the scope of the hybrid financial instrument rule, rather than eligible for a specific exemption, the Presidency said.

Reverse hybrid mismatches

 The directive also adds that if a hybrid entity is regarded as a taxable person in the Member State where is incorporated or established, that hybrid entity must be regarded as a resident of that Member State and taxed on its income to the extent that this income is not otherwise taxed under the laws of the Member State or any other jurisdiction.

Effective dates

Regarding implementation, Member States must adopt and publish, by 31 December 2019, laws, regulations, and administrative provisions necessary to comply with the directive.

Implementation is set for 1 January 2020, and for 1 January 2022, as concerns the specific provision on reverse hybrid mismatches (Article 9a).

The ATAD II compromise proposal was first offered 17 February by the Presidency, following discussions in Coreper (Committee of the Permanent Representatives of the Governments of the Member States to the European Union) on 15 February.