On February 21, 2017, the Council of the European Union (ECOFIN, in this context) reached political consensus on a directive (known as ATAD 2) amending the EU Anti-Tax Avoidance Directive as adopted on July 17, 2016 (EU 2016/1164, known as ATAD or ATAD 1). ATAD 1 provided for rules to neutralize hybrid mismatch arrangement, but only between two EU member states (Member States). The present and final ATAD 2 endorsed by the ECOFIN tackles hybrid mismatch structures that involve non-EU countries and a wider variety of mismatches.
Application to non-EU countries
ATAD 2 tackles mismatches that happen between an EU Member State and a non-EU country. For example, in a typical hybrid mismatch structure involving a non-EU country, as illustrated below, ATAD 2 would require the Member State, MS 1, to deny a deduction for the payment made to the hybrid entity, even though the participants of the entity are not in one of the Member States.
The new rules also cover the so called imported hybrid mismatches. In particular, Article 9(3) authorizes a Member State to “…deny a deduction for any payment by a taxpayer to the extent that such payment directly or indirectly funds deductible expenditure giving rise to a hybrid mismatch…”. In a typical hybrid mismatch structure illustrated in Figure 1, ATAD 2 would authorize MS 2 to deny a deduction for the interest paid to MS 1 if it funds a hybrid mismatch payment. However, MS 2 is unable to apply this rule if MS 1 already denies deduction for the payment made to the hybrid.
Other mismatches covered
ATAD 2 covers other mismatches such as:
- Permanent establishment (PE) mismatches – Member States are required to deny deduction (and include as income) payments to/from a head office to its PE, or among PEs, that have a deduction, non-inclusion outcome
- Dual resident mismatches – Member States are required to disallow a deduction for taxpayers that are resident for tax purposes in two or more jurisdictions in certain circumstances
- Reverse hybrid mismatches – Member States shall deem a reverse hybrid entity as a resident and shall tax its income to the extent that the income is not already effectively taxed elsewhere (in the Member State or any other jurisdiction)
- Hybrid transfers – Member States shall limit the relief from tax where financial instruments have been transferred in such a way to produce such relief for multiple parties
Member States may exclude from their implementation the defensive measures (i.e. deeming income as a payment where a deduction has been given for the same payment in another state) in relation to PE mismatches and hybrid entity mismatches.
For banks and financial institutions, the hybrid mismatch rules do not apply to some intra-group hybrid instruments that are used for regulatory purposes because of their loss absorption capacity (such as, contingent convertibles or CoCos), but this exception will expire on 31 December 2022.
The new rules must be implemented by EU Member States from 1 January 2020.
Implementation of the reverse hybrid rules can be delayed further by two years, till 1 January 2022.
ATAD 2 is expected to have a substantial impact on many existing structures used by non-EU businesses to invest into Europe. These structures would have to be reviewed in light of ATAD 2 and how it is implemented by EU Member States. For example, it could be relevant to assess, when Member States implement ATAD 2 in their domestic law to deal with third-country mismatches, how each of them implement the apportionment rules that are envisaged in the phrase “to the extent that”. It should be interesting also to see how far Member States are prepared to trace the connecting payments when implementing the notion of “directly or indirectly”.
Banks and financial institutions relying on intra-group hybrid financial instruments that have loss absorption capacity have until 31 December 2022 to find a different tax deductible alternative.