Hybrid mismatch arrangements are tax planning strategies that exploit differences in the tax treatment of an entity or financial instrument between two or more countries. These arrangements are designed to take advantage of divergent national tax rules to reduce a company’s overall tax liability. This can lead to one of the following outcomes:

• Double Non-Taxation: The income is not taxed in either of the countries involved.
• Double Deduction of Expenses: The same expense is deducted in multiple jurisdictions, leading to a reduced overall tax burden.
• Mismatch of Timing: Two jurisdictions may apply different timing rules in the recognition of an income or a deduction, creating a tax benefit in one jurisdiction without a corresponding tax burden in the other.

Common Types of Hybrid Mismatches

• Hybrid Entities: These are entities that are treated differently for tax purposes in different jurisdictions in ways that create tax advantages. This difference in treatment can create tax mismatches. E.g., A company in Country A sets up a subsidiary that is considered a corporation for tax purposes in Country A but is treated as a pass-through entity in Country B. A pass-through entity is a business structure where the income, deductions, credits and other tax items pass directly to the owners or shareholders, rather than being taxed at the entity level. The income of this subsidiary is taxed in Country A but not in Country B, leading to potential double non-taxation.
• Hybrid Financial Instruments: These are instruments that are treated as debt in one jurisdiction, which allows interest deductions, and as equity in another jurisdiction, which may allow tax-free dividends. This creates a situation where one jurisdiction provides a deduction and the other treats the income as exempt, leading to a mismatch. E.g., A multinational group might set up a financing arrangement where an interest payment made by a subsidiary in Country A (which allows interest deductions) is treated as a dividend in Country B (which does not tax dividends). As a result, the payment is deducted in one country without being taxed in the other.
• Hybrid Transfer Pricing: This occurs when two jurisdictions treat a transaction between related parties differently. E.g., Company X has subsidiaries in Country A and Country B. The subsidiary in Country A makes a payment to the one in Country B for the use of intellectual property (IP). In Country A, the payment is treated as a royalty and is deductible for tax purposes. However, in Country B, it is classified as a capital gain and is not taxed. This results in a hybrid mismatch, where the payment is deducted in one country but not taxed in the other, reducing the multinational’s overall tax liability without any income being taxed.

Consequences of Hybrid Mismatches

• Tax Evasion: The primary concern is that hybrid mismatch arrangements allow multinational corporations to evade paying taxes that they would otherwise owe, contributing to base erosion in countries where profits are generated but not taxed.
• Increased Scrutiny: Governments and tax authorities worldwide have increased their focus on hybrid mismatches, making such arrangements a target for audits and legal challenges. Countries that are part of the OECD’s BEPS initiative are more likely to implement measures to prevent hybrid mismatches, including imposing new reporting requirements on multinational corporations.
• Complexity and Costs: For businesses, hybrid mismatch arrangements are becoming increasingly difficult to implement due to new regulations and compliance requirements. The need to stay ahead of regulatory changes adds complexity and compliance costs.

BEPS Action 2: Neutralizing the Effects of Hybrid Mismatch Arrangements

In response, the OECD introduced guidelines to curb tax avoidance and ensure that multinational corporations pay taxes in line with their actual economic activities. The Action 2 rules focus on:

• Denial of Tax Benefits: When a tax benefit (e.g., a deduction) is claimed in one jurisdiction, the other jurisdiction should deny a corresponding benefit to prevent improper tax advantages.
• Elimination of Double Non-Taxation: Countries should align their tax rules to ensure that income is taxed at least once, preventing situations where income is not taxed in multiple jurisdictions.
• Adjustment of Hybrid Instruments and Entities: Countries should amend their domestic rules to address hybrid mismatches, either by disregarding or recharacterizing hybrid instruments or entities that create inconsistent tax outcomes.

Companies must now carefully assess their tax structures to ensure compliance with these evolving international rules and avoid unintended tax consequences.

Although hybrid mismatch arrangements are not always intentionally structured as stateless income strategies, they can result in situations where income is not taxed by any jurisdiction, effectively creating stateless income. The OECD rules aim to combat BEPS, which undermines the integrity of the global tax system.

This material is intended solely for informational purposes and should not be relied upon without seeking specific professional advice on the matter. Should you have any questions regarding this topic, please feel free to contact our team at info@ke.andersen.com or +254 20 5100263.

Contributors & Contact Persons

Irene Masecko

Tax Associate

irene.masecko@ke.andersen.com

Marco Manyenze

Associate Director

marco.manyenze@ke.andersen.com