On February 21st, 2017, the EU Member States agreed on a directive (or “ATAD 2”) that amends the ATAD 1 (*1) on article 9, which covered certain hybrid mismatches between EU Member States. The ATAD 1 introduced rules against tax avoidance practices that directly affect functioning of the internal market and proposed minimum standard rules that all Member States need to implement to attack hybrid mismatches in EU situations. However, third countries also take advantage of hybrid mismatches to reduce their overall tax liability in the EU. As a consequence, ATAD 2 goes further than the ATAD 1 and introduces minimum standards for all EU Member States regarding hybrid mismatches with third countries.
In this alert, we will explain the ATAD 2 in more detail. The Member States need to implement the provisions into national law by December 31st, 2019 and they need to be applied by January 1st, 2020. However, the so-called Reverse Hybrids rules will only have to be implemented by December 31, 2021 and be applied as from January 1, 2022. However, payments made to reverse hybrids would not be deductible anymore from 1 January 2020.
Besides the provisions regarding to hybrid mismatches with third parties, ATAD 2 provides rules consistent with those recommended by the OECD in the 2015 Final BEPS Report Action 2. The Report should be used as a source of illustration and interpretation to the extent the rules are consistent with the provisions of ATAD 2 and EU Law.
Scope of ATAD 2
ATAD 2 applies to all taxpayers subject to corporate tax in one or more Member States, including permanent establishments in one or more EU Member States of entities resident for tax purposes in a third country. ATAD 2 only covers mismatches in associated enterprises. Associated is defined and covers direct and indirect interests of 25% or more. For certain types of mismatches the percentage is increased to 50%.
As mentioned in ATAD 2, the scope is to mitigate the harmful tax effects of hybrid mismatches in the internal market. Hybrid mismatches are differences in legal characterization of an entity or a financial instrument, dual tax residency and the treatment of a commercial presence as a permanent establishment and reverse hybrid entities. Below, we will discuss the most relevant mismatches.
Hybrid entity mismatch resulting in double taxation
In cases of differences in legal characterization of entities, a double deduction may occur of the same payment, expenses and losses, in other words a deduction in both states. The deduction should be denied in the investor Member State or in the payer Member State. Deduction without inclusion arising due to the tax status of a payee or the fact that an instrument is held subject to the terms of a special regime should not be treated as a hybrid mismatch.
Hybrid entity mismatch resulting in deduction without inclusion and reverse hybrid mismatches
In case a deduction is made in one Member State because of the use of a Hybrid entity, without inclusion of its payment in the tax base of the receiving company, the deduction should be denied in the Member State of the payer or the payment has to be included as taxable income in the Member State of the payee.
If a deduction is made in one Member State because of the use of a hybrid transfer, without inclusion of its payment in the tax base of the receiving company the Member State of the payer should deny the deduction of the payment. These rules should not apply if the underlying return on the transferred instrument is included in the taxable income of one of the parties. In third-country situations, a hybrid transfer may lead to a payment that is treated as derived simultaneously by different tax payers in different jurisdictions whereby both taxpayers claim withholding tax credits on the same payment. In that situation the amount of the credit is limited in proportion to taxpayers net taxable income.
Hybrid permanent establishment mismatches
A hybrid permanent establishment mismatch may lead to non-taxation without inclusion. In this case, the Member State should include the income attributed to that permanent establishment. This is also applicable in third-country situations. However, in case income is exempt under a tax treaty between a Member State and a third country, the above does not apply.
In case the hybrid permanent establishment mismatch lead to a double deduction, the Member State denies the deduction of the payment, expenses or losses if and to the extent the payment is deductible against income that is not considered dual-inclusion income. In case this rule is not applied, the Member State where the head office is located should include the income in its taxable base and deny double tax relief.
If it leads to a deduction without inclusion, the EU Member State denies the deduction. If this is not applied, the Member State should include the payment in their tax base to the extent of the mismatch.
For imported mismatches, it is proposed to include rules that disallow the deduction of a payment if the income on such a payment is set-off against a deduction that arises under a hybrid mismatch arrangement giving rise to double deduction or a deduction without inclusion between third countries. The aim of these rules is to maintain the integrity of the hybrid mismatch rules by taking away the incentive for multinational groups to enter into hybrid mismatch situations. This is in our view difficult as to uncertain how this should be applied. What it seems to indicate is that if the hybrid mismatch rules are (deemed to be) avoided through the introduction of a non-hybrid instrument with a third country, the deduction in the member state is not allowed.
Reverse hybrid mismatches
As from January 1st, 2022 a hybrid entity should be regarded as a resident of the Member State of incorporation or establishment and taxed on its income to the extent this income is not taxed in another country. This rule shall not apply to collective investment vehicles.
Reverse hybrid mismatches may also fall under the scope of other provisions of ATAD 2. As a result thereof, a payment made to a reverse hybrid that leads to a deduction without inclusion, could also lead to a denial of the deduction as of January 1st, 2020. ATAD 2 states that the reverse hybrid mismatch provision overrides the other rules.
However, it is unclear how the other rules should apply in the period between January 1st, 2020 and January 1st, 2022, the date that the hybrid entity rule will be applicable.
Collective investment vehicles are excluded from the scope of the provision on reversed hybrid mismatches.
Dual resident mismatches
In case of a dual resident mismatch, double deduction may occur. The Member State should deny the deduction of the payment, but only to the extent that this is set off against an amount that is not treated as income under the law of the third-country against non dual-inclusion income. In case both countries are Member States, the deduction should be denied by the Member State of which the taxpayer is deemed not to be a resident under the tax treaty between those Member States.
On April 2017, the European Parliament will formally issue its opinion on the EC proposal. Thereafter, ATAD 2 will be submitted for formal adoption at a ECOFIN Council meeting.
Impact of the proposed measures for Dutch CV/BV structures
In our view, the reverse hybrid mismatch rule is most relevant from a Dutch perspective. The proposed measures have major impact on for instance CV/BV structures. Interest and royalty payments from BV to CV are deductible in the Netherlands and not included at the level of CV (which is a hybrid entity), or in the US. Under the new rules, the Netherlands and/ or EU member states should deny the deduction as of January 1st 2020 and the Netherland should tax the CV as of January 1st, 2022. Note that this is not the only situation where the new rules apply. However, on these structures it will have significant impact.
(*1) Council Directive (EU) 2016/1164 dated July 12, 2016